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Summary of My Post-CPI Tweets (June 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. 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.

  • OK, CPI day at last. We get to find out if Powell meant “transitory” in the one-month sense (probably not) or in the 3-6 month sense (more likely).
  • After all we have had three weak core CPI figures in a row: 0.110% for Feb, 0.148% in March, 0.138% in April. Three 0.1%s, rounded.
  • Last month the culprit was used cars, -1.3% m/m, and Apparel at -0.8% m/m, the latter due to a methodology change. These are both short-term transitory, probably.
  • Meanwhile, the evidence that core is being infected these last three months by tail events is in the median CPI, which was +0.26%, +0.27%, and +0.20% the last 3 months.
  • Housing, on the other hand, remains strong, and this should continue for a bit; Medical Care remains weak with pharma especially (+0.1% y/y)…and I think that is “longer-term transitory” that should start to retrace higher.
  • I am expecting a return to normalcy, not so much a rebound, in autos and apparel. But that should be enough to hit the consensus figures of 0.21% on core, 2.09% y/y.
  • Longer-term, the fact that interest rates have fallen so far suggests that the small rebound we have seen over the last year and a half in money velocity may have trouble extending.
  • So I think Median probably peaks late this year or early next, though I don’t expect it to fall off a cliff, either, in this recession.
  • Grabbing coffee. Back in 11 minutes.
  • So maybe a liiiiiittle more transitory than we thought! Core +0.11% m/m, +2.00% y/y.
  • Last 12 months. The comp is easier next month, but none of the last 4 months would have exceeded it anyway!

  • Apparel basically flat m/m, which is approximately what I expected…-3.06% y/y though, which includes the methodology change.
  • CPI-Used Cars and Trucks was again down sharply m/m. -1.38%. That’s unlikely. Pushes y/y to +0.28%, Black Book has it about 1% above that.

  • Housing: OER +0.26% m/m, Primary Rents +0.24%. Actually those aren’t far from the trends (y/y in each case declined a couple of hundredths, to 3.34% and 3.73% respectively), but last month had been chippier.
  • Medical Care (and then I’m going to take a few minutes and dig deeper on some of these)…Medicinal Drugs (pharma) went into deflation. -0.11% m/m, -0.82% y/y. Chart in a moment. Doctor’s Services roughly unch, but only 0.30% y/y. Hospital Services bounced a bit, 1.30% y/y.
  • Even with the bounce, Hospital Services is lower than two months ago, 3 months ago, etc. One year ago it was 4.70% y/y. Hospital Services is the largest component of the Medical Care subindex.
  • Here is the y/y chart for drugs. Now, it’s very hard to measure this because there is tremendous dispersion in consumer costs for prescription drugs…massive differences based on which outlet, formulary, insurance, etc you have. Doing a lot of work on this. Sooo…

  • this is the y/y picture for NONprescription drugs, which are much easier to measure. Basically no chg. So either prescriptn drug mkt is getting much more competitive (I doubt it), there is some change in collection method (possible), or a shift showing up as change.

  • there is no lower-level index for drugs so we can’t really dig any deeper on that unfortunately. But it’s significant, not only for the CPI of course but for consumers generally (and the budget deficit) if health care costs really ARE slowing in a permanent way.
  • CPI – College Tuition and Fees, essentially unch at 3.81% vs 3.86% y/y. But well off the lows.

  • Now what does that last picture look like…oh, yeah, the S&P Target Tuition Inflation Index (my baby).

  • Core inflation ex-housing down to 1.04%, the lowest level since February 2018. Still nowhere near the lows, nowhere near deflation, and with lots of transitory stuff in it.

  • Core goods prices still in deflation, -0.2%. But lagged effect of the dollar’s 2017 selloff should just now be starting to wash into the core goods data. And we still haven’t seen the tariff effect yet. So this is still to come and the reason I don’t think we’ve peaked yet.

  • WEIRD: Biggest declines on the month were used cars & trucks (-15.3% annualized), Leased cars & trucks (-13.8%). Biggest gainers: Car and Truck Rental (+26.5%), Public Transportation (+24.8%).
  • Early estimate for Median CPI is +0.21% m/m, making y/y 2.81%. So, again, it’s a tails story.
  • Sorry, didn’t calculate the sheet for y/y. Should be 2.76% y/y for median, down from 2.80%.
  • Here is m/m Median CPI. Notice there’s really no major slowdown here. It’s been pretty steady and rising slightly y/y for a while. Nothing below 0.2% m/m since last August.

  • OK, four pieces and then we’ll sum up. Piece 1 is food and energy.

  • Piece 2 is core goods. As I said, I expect this to turn back higher. This is where you find Used Cars and Apparel…so transitory stuff is big here. This is also where tariffs fall heaviest.

  • Piece 3 is Core Services less Rent of Shelter. Same story here: “What is up with medical care?” It may be that since consumers under the ACA end up paying out of pocket for a much larger share, they’re bargaining harder. That could be why it feels so much worse than this.

  • Finally, rent of shelter – same old same old. No deflation while this remains steady as a rock.

  • So, in sum. I do think that Powell is right in focusing on the “transitory” inflation slowdown. Better measures, such as Median (see below for Median vs core), show no significant slowdown yet.

  • …and it’s hard to see where a slowdown would come from. Medical Care is already very slow. Core goods is already very slow, with negative tails already in the data but not much sign yet of the tariff effect sure to come. Housing is solid.
  • So for now, I expect median inflation to continue to crawl higher. As we get later in the year, though, unless interest rates rebound a lot higher there’s a decent chance that money velocity droops again.
  • Now, money velocity is already REALLY low so it may not. This chart isn’t our best model but it suggests velocity is already too low for the level of int rates (I’m not sure it’s a linear function near zero though). It was responding, but lower int rates may truncate a bounce.

Nothing more really to add – I will say that although Powell is right and these are transitory factors, I have lost faith that the Chairman is a “different sort” of Fed Chair since he doesn’t have an academic background. He was at first, but appears to have been captured by the econocognoscenti. Ergo, I expect the Fed will ignore the fact that inflation is still drifting higher, and start to cut rates as the growth figures make it ever clearer that the economy is heading towards (if not already in) recession. Long-end yields are already 110bps or more off the highs, so I think the bond market already has more than half its recession-rally finished (I don’t think we’ll have new low yields this cycle since I don’t think inflation will collapse and I don’t think the recession will be as bad). But stocks haven’t even begun their earnings-recession selloff, so…

Tariffs and Subsidies…on Money

June 7, 2019 1 comment

Many, many years ago (27, actually) I wrote a paper on how a tariff on oil actually has some beneficial effects which needed to be balanced against the beneficial effect that a lower oil price has on economic growth. But since the early 1990s until 2015 or so I can count on the fingers of one hand how many times the issue of tariffs came up in thoughts about the economy and markets. To the extent that anyone thought about them at all, it was to think about how lowering them has an unalloyed long-term positive effect. Which, for the most part, it does.

But the economics profession can sometimes be somewhat shamanistic on the topic of tariffs. Tariffs=bad; time for the next chapter in the book. There is much more complexity to the topic than that, as there is with almost any economic topic. Reducing economics to comic-book simplicity only works when there is one overwhelmingly correct idea, like “when demand for a good goes up, so does the equilibrium price.” The end: next chapter.

Tariffs have, though, both short-term and long-term effects. In the long-term, we all agree, the effects of raising tariffs are deleterious. For any given increase in money and velocity, we end up with lower growth and higher inflation, all else equal. It is important to realize that these are largely one-time effects although smeared out over a long period. That is, after equilibrium is reached if tariffs are not changed any longer, tariffs have no large incremental effect. It is the change in tariffs that matters, and the story of the success of the global economy in terms of having decent growth with low inflation for the last thirty years is largely a story of continuously opening trade. As I’ve written previously, this train was just about running out of track anyway so that we were likely to go back to a worse combo of growth and inflation, but reversing that trend would lead to significantly worse combinations of growth and inflation in the medium-to-long term.

In the short-term, however, tariffs can have a positive effect (if they are expected to remain) on the tariff-imposing country, assuming no retaliation (or even with retaliation, if the tariff-imposing country is a significant net importer). They raise employment, and they raise the wage of the employed. They even may raise the real wage of the employed if there is economic slack. The chart below shows the y/y change in manufacturing jobs, and ex-manufacturing jobs, for the last 40 years. Obviously, the manufacturing sector has been shrinking – a story of increased productivity, but also of trade liberalization as manufacturing was offshored. The Obama-era work programs (e.g. “Cash for Clunkers”) temporarily reversed some of that differential decline, but since 2016 – when we got a new President – manufacturing payrolls growth has caught up to non-manufacturing. That’s not a surprise – it’s the short-term effect of tariffs.

The point is that tariffs are a political winner in the short-term, which is one reason I think that people are overestimating the likelihood that “Tariff Man” is going to rapidly concede on trade and lower tariffs. If the Administration gets a clear “win” in trade negotiations, then I am sure the President is amenable to reversing tariffs. But otherwise, it doesn’t hurt him in the heavy manufacturing states. And those states turn out to be key.

(This is a relative observation; it doesn’t mean that total payrolls will rise. The economic cycle still has its own momentum, and while tariffs can help parts of the economy in the short term it doesn’t change the fact that this cycle was very long in the tooth with lots of imbalances that are overdue for correction. It is no real surprise that employment is softening, even though it is a lagging indicator. The signs of softening activity have been accumulating for a while.)

But in the long run, we all agree – de-liberalizing trade is a bad deal. It leads among other things to bloat and inefficiency in protected sectors (just as any decrease in competition tends to do). It leads to more domestic capacity than is necessary, and duplicated capacity in country A and country B. It promotes inefficiency and unbalanced growth.

So why, then, are investors and economists so convinced that putting tariffs or subsidies on money has good (or even neutral) long-term effects? When the Fed forces interest rates higher or lower, by arbitrarily setting short-term rates or by buying or selling long-term bonds – that’s a tariff or a subsidy. It is protecting interest-rate sensitive sectors from having interest rates set by competition for capital. And, as we have seen, it leads in the long run to inefficient building of capacity. The Fed evinces concern about the amount of leverage in the system. Whose fault is that? If you give away free ice cream, why are you surprised when people get fat?

The only way that tariffs, and interest rate manipulations, have a chance of being neutral to positive is if they are imposed as a temporary rebalancing (or negotiating) measure and then quickly removed. In the case of Federal Reserve policy, that means that after cutting rates to address a temporary market panic or bank run, the central bank quickly moves back to neutral. To be clear, “neutral” means floating, market-determined rates where the supply and demand for capital determines the market-clearing rate. If investors believed that the central bank would pursue such a course, then they could evaluate and plan based on long-term free market rates rather than basing their actions on the expectation that rates would remain controlled and protective.

It is no different than with tariffs. So for central bankers criticizing the trade policy of the Administration, I say: let those among you who are without sin cast the first stone.

What if ‘Excess Reserves’ Aren’t Really Excess?

March 4, 2019 2 comments

One intriguing recent suggestion I have heard recently is that the “Excess” reserves that currently populate the balance sheet of the Federal Reserve aren’t really excess after all. Historically, the quantity of reserves was managed so that banks had enough to support lending to the degree which the Fed wanted: when economic activity was too slow, the Fed would add reserves and banks would use these reserves to make loans; when economic activity was too fast, the Fed would pull back on the growth of reserves and so rein in the growth of bank lending. Thus, at least in theory the Open Markets Desk at the New York Fed could manage economic activity by regulating the supply of reserves in the system. Any given bank, if it discovered it had more reserves than it needed, could lend those reserves in the interbank market to a bank that was short. But there was no significant quantity of “excess” reserves, because holding excess reserves cost money (they didn’t pay interest) – if the system as a whole had “too many” reserves, banks tended to lend more and use them up. So, when the Fed wanted to stuff lots of reserves into the system in the aftermath of the financial crisis, and especially wanted the banks to hold the excess rather than lending it, they had to pay banks to do so and so they began to pay interest on reserves. Voila! Excess reserves appeared.

But there is some speculation that things are different now because in 2011, the Basel Committee on Banking Supervision recommended (and the Federal Reserve implemented, with time to comply but fully implemented as of 2015) a rule that all “Systematically Important Financial Institutions” (mainly, really big banks) be required to maintain a Liquidity Coverage Ratio (LCR) at a certain level. The LCR is calculated by dividing a bank’s High Quality Liquid Assets (HQLA) by a number that represents its stress-tested 30-day net outflows. That is, the bank’s liquidity is expressed as a function of the riskiness of its business and the quantity of high-quality assets that it holds against these risks.

In calculating the HQLA, most assets the bank holds receive big discounts. For example, if a bank holds common equities, only half of the value of those equities can be considered in calculating this numerator. But a very few types of assets get full credit: Federal Reserve bank balances and Treasury securities chief among them.[1]

So, since big banks must maintain a certain LCR, and reserves are great HQLA assets, some observers have suggested that this means the Fed can’t really drain all of those excess reserves because they are, effectively, required. They’re not required because they need to be held against lending, but because they need to be held to satisfy the liquidity requirements.

If this is true, then against all my expectations the Fed has, effectively, done what I suggested in Chapter 10, “My Prescription” of What’s Wrong with Money? (Wiley, 2016). I quote an extended section from that book, since it turns out to be potentially spot-on with what might actually be happening (and, after all, it’s my book so I hereby give myself permission to quote a lengthy chunk):

“First, the Federal Reserve should change the reserve requirement for banks. If the mountain will not come to Mohammed, then Mohammed must go to the mountain. In this case, the Fed has the power (and the authority) to, at a stroke, redefine reserves so that all of the current “excess” reserves essentially become “required” reserves, by changing the amount of reserves banks are required to hold against loans. No longer would there be a risk of banks cracking open the “boxes of currency” in their vaults to extend more loans and create more money than is healthy for an economy that seeks noninflationary growth. There would be no chance of a reversion to the mean of the money multiplier, which would be devastating to the inflation picture. And the Open Markets Desk at the Fed would immediately regain power over short-term interest rates, because when they add or subtract reserves in open market operations, banks would care.

“To be sure, this would be awful news for the banks themselves and their stock prices would likely take a hit. It would amount to a forcible deleveraging, and impair potential profitability as a result. But we should recognize that such a deleveraging has already happened, and this policy would merely recognize de jure what has already happened de facto.

“Movements in reserve requirements have historically been very rare, and this is probably why such a solution is not being considered as far as I know. The reserve requirement is considered a “blunt instrument,” and you can imagine how a movement in the requirement could under normal circumstances lead to extreme volatility as the quantity of required reserves suddenly lurched from approximate balance into significant surplus or deficit. But that is not our current problem. Our current problem cries out for a blunt instrument!

“While the Fed is making this adjustment, and as it prepares to press money growth lower, they should work to keep medium-term interest rates low, not raise them, so that money velocity does not abruptly normalize. Interest rates should be normalized slowly, letting velocity rise gradually while money growth is pushed lower simultaneously. This would cause the yield curve to flatten substantially as tighter monetary conditions cause short-term interest rates in the United States to rise.

“Of course, in time the Fed should relinquish control of term rates altogether, and should also allow its balance sheet to shrink naturally. It is possible that, as this happens, reserve requirements could be edged incrementally back to normal as well. But those decisions are years away.”

If, in fact, the implementation of the LCR is serving as a second reserve requirement that is larger than the reserve requirement that is used to compute required and “excess” reserves, then the amount of excess reserves is less than we currently believe it to be. The Fed, in fact, has made some overtures to the market that they may not fully “normalize” the balance sheet specifically because the financial system needs it to continue to supply sufficient reserves. If, in fact, the LCR requirement uses all of the reserves currently considered “excess,” then the Fed is, despite my prior beliefs, actually operating at the margin and decisions to supply more or fewer reserves could directly affect the money supply after all, because the reserve requirement has in effect been raised.

This would be a huge development, and would help ameliorate the worst fears of those of us who wondered how QE could be left un-drained without eventually causing a move to a much higher price level. The problem is that we don’t really have a way to measure how close to the margin the Fed actually is; moreover, since Treasuries are a substitute for reserves in the LCR it isn’t clear that the margin the Fed wants to operate on is itself a bright line. It is more likely a fuzzy zone, which would complicate Fed policy considerably. It actually would make the Fed prone to mistakes in both directions, both over-easing and over-tightening, as opposed to the current situation where they are mostly just chasing inflation around (since when they raise interest rates, money velocity rises and that pushes inflation higher, but raising rates doesn’t also lower money growth since they’re not limiting bank activities by reining in reserves at the margin).

I think this explanation is at least partly correct, although we don’t think the condition is as binding as the more optimistic assessments would have it. The fact that M2 has recently begun to re-accelerate, despite the reduction in the Fed balance sheet, argues that we are not yet “at the margin” even if the margin is closer than we thought it was previously.


[1] The assumption in allowing Treasuries to be used at full value seems to be that in a crisis the value of those securities would go up, not down, so no haircut is required. Of course, that doesn’t always happen, especially if the crisis were to be caused, for example, by a failure of the government to pay interest on Treasuries due to a government shutdown. The more honest reason is that if the Fed were to haircut Treasuries, banks would hold drastically fewer Treasuries and this would be destabilizing – not to mention bad for business on Capitol Hill.

What’s Bad About the Fed Put…and Does Powell Have One?

January 8, 2019 3 comments

Note: Come hear me speak this month at the Taft-Hartley Benefits Summit in Las Vegas January 20-22, 2019. I will be speaking about “Pairing Liability Driven Investing (LDI) and Risk Management Techniques – How to Control Risk.” If you come to the event I’ll buy you a drink. As far as you know.

And now on with our irregularly-scheduled program.


Have we re-set the “Fed put”?

The idea that the Fed is effectively underwriting the level of financial markets is one that originated with Greenspan and which has done enormous damage to markets since the notion first appeared in the late 1990s. Let’s review some history:

The original legislative mandate of the Fed (in 1913) was to “furnish an elastic currency,” and subsequent amendment (most notably in 1977) directed the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” By directing that the Federal Reserve focus on monetary and credit aggregates, Congress clearly put the operation of monetary policy a step removed from the unhealthy manipulation of market prices.

The Trading Desk at the Federal Reserve Bank of New York conducts open market operations to make temporary as well as permanent additions to and subtractions from these aggregates by repoing, reversing, purchasing, or selling Treasury bonds, notes, and bills, but the price of these purchases has always been of secondary importance (at best) to the quantity, since the purpose is to make minor adjustments in the aggregates.

This operating procedure changed dramatically in the global financial crisis as the Fed made direct purchase of illiquid securities (notably in the case of the Bear Stearns bankruptcy) as well as intervening in other markets to set the price at a level other than the one the free market would have determined. But many observers forget that the original course change happened in the 1990s, when Alan Greenspan was Chairman of the FOMC. Throughout his tenure, Chairman Greenspan expressed opinions and evinced concern about the level of various markets, notably the stock market, and argued that the Fed’s interest in such matters was reasonable since the “wealth effect” impacted economic growth and inflation indirectly. Although he most-famously questioned whether the market was too high and possibly “irrationally exuberant” in 1996, the Greenspan Fed intervened on several occasions in a manner designed to arrest stock market declines. As a direct result of these interventions, investors became convinced that the Federal Reserve would not allow stock prices to decline significantly, a conviction that became known among investors as the “Greenspan Put.”

As with any interference in the price system, the Greenspan Put caused misallocation of resources as market prices did not truly reflect the price at which a willing buyer and a willing seller would exchange ownership of equity risks, since both buyer and seller assumed that the Federal Reserve was underwriting some of those risks. In my first (not very good) book Maestro, My Ass!, I included this chart illustrating one way to think about the inefficiencies created:

The “S” curve is essentially an efficient frontier of portfolios that offer the best returns for a given level of risk. The “D” curves are the portfolio preference curves; they are convex upwards because investors are risk-averse and require ever-increasing amounts of return to assume an extra quantum of risk. The D curve describes all portfolios where the investor is equally satisfied – all higher curves are of course preferred, because the investor would get a higher return for a given level of risk. Ordinarily, this investor would hold the portfolio at E, which is the highest curve he/she can achieve given his/her preferences. The investor would not hold portfolio Q, because that portfolio has more risk than the investor is willing to take for the level of expected return offered, and he/she can achieve a ‘better’ portfolio (higher curve) at E.

But suppose now that the Fed limits the downside risk of markets by providing a ‘put’ which effectively caps the risk at X. Then, this investor will in fact choose portfolio Q, because portfolio Q offers higher return at a similar risk to portfolio E. So the investor ends up owning more risky securities (or what would be risky securities in the absence of the Fed put) than he/she otherwise would, and fewer less-risky securities. More stocks, and fewer bonds, which raises the equilibrium level of equity prices until, essentially, the curve is flat beyond E because at any increment in return, for the same risk, an investor would slide to the right.

So what happened? The chart below shows a simple measure of expected equity real returns which incorporates mean reversion to long-term historical earnings multiples, compared to TIPS real yields (prior to 1997, we use Enduring Investments’ real yield series, which I write about here). Prior to 1987 (when Greenspan took office, and began to promulgate the idea that the Fed would always ride to the rescue), the median spread between equity expected returns and long-term real yields was about 3.38%. That’s not a bad estimate of the equity risk premium, and is pretty close to what theorists think equities ought to offer over time. Since 1997, however – and here it’s especially important to use median since we’ve had multiple booms and busts – the median is essentially zero. That is, the capital market line averages “flat.”

If this makes investors happy (because they’re on a higher indifference curve), then what’s the harm? Well, this put (a free put struck at “X”) is not costless even though the Fed is providing it for free. If the Fed could provide this without any negative consequences, then by all means they ought to because they can make everyone happier for free. But there is, of course, a cost to manipulating free markets (Socialists, take note). In this case the cost appears in misallocation of resources, as companies can finance themselves with overvalued equity…which leads to booms and busts, and the ultimate bearer of this cost is – as it always is – the citizenry.

In my mind, one of the major benefits that Chairman Powell brought to the Chairmanship of the Federal Reserve was that, since he is not an economist by training, he treated economic projections with healthy and reasonable skepticism rather than with the religious faith and conviction of previous Fed Chairs. I was a big fan of Powell (and I haven’t been a big fan of many Chairpersons) because I thought there was a decent chance that he would take the more reasonable position that the Fed should be as neutral as possible and do as little as possible, since after all it turns out that we collectively suck when it comes to our understanding of how the economy works and we are unlikely to improve in most cases on the free market outcome. When stocks started to show some volatility and begin to reprice late last year, his calculated insouciance was absolutely the right attitude – “what Fed put?” he seemed to be saying. Unfortunately, the cost of letting the market re-adjust is to let it fall a significant amount so that there is again an upward slope between E and Q, and moreover let it stay there.

The jury is out on whether Powell does in fact have a price level in mind, or if he merely has a level of volatility in mind – letting the market re-adjust in a calm and gentle way may be acceptable to him, with his desire to intervene only being triggered by a need to calm things rather than to re-inflate prices. I’m hopeful that is the case, and that on Friday he was just trying to slow the descent but not to arrest it. My concern is that while Powell is not an economist, he did have a long career in investment banking, private equity, and venture capital. That might mean that he respects the importance of free markets, but it also might mean that he tends to exaggerate the importance of high valuations. Again, I’m hopeful, and optimistic, on this point. But that translates to being less optimistic on equity prices, until something like the historical risk premium has been restored.

Spinning Economic Stories

January 4, 2019 5 comments

As economists[1] we do two sorts of things. We do quantitative work, and we tell stories.

One of the problems with economics is that we aren’t particularly regimented about how we convert data into stories and about how we look at stories to decide how to interrogate the data. So what tends to happen is that we have a phenomenon and then we look at what story we like and decide if that’s a reasonable way to explain the data…without asking if there isn’t a more reasonable way to explain the data, or at least another way that’s equally consistent with the data. I’m not saying that everyone does this, just that it’s disturbingly common especially among people being paid to be storytellers and for whom a good story is really important.

So for example, there is a well -known phenomenon that inflation tends to accelerate after the Fed begins raising interest rates.[2] Purporting to explain this phenomenon, here is a popular story that the Fed is just really smart, so they’re ahead of inflation, and when they seeing it moving up just a little bit they can jump on it real quick and get ahead of it and so inflation goes up…but the apparent causality is there because we just knew it was going to go up and acted before the observation of the higher inflation happened. This is basically Keynesian theory combined with “brilliant person” theory.

There is another theory that is consistent with this, of course: monetarism, which explains that increasing interest rates actually causes inflation to move higher, by causing velocity to increase. But, because this isn’t the popular story, this doesn’t get matched up to the data very frequently. In my mind it’s a better theory, because it doesn’t require us to believe that the Fed is super brilliant to make it work. (And, not to get snarky, but the countervailing evidence versus Fed staff economist genius is pretty mountainous). Of course, economists – and the Fed economists in particular – like theories that make them look like geniuses, so they prefer the prior explanation.

But again, as economists we don’t have a good and rigorous way to say that one way is the ‘preferred’ story or to look at other stories that are consistent with our data. We tend to look at what part of the data supports our story – in other words, confirmation bias.

Why this is relevant now is that the Fed is in fact tightening and inflation is in fact heading higher, and the story being pushed by the Fed and some economists is “good thing the Fed is tightening, because it looks like inflation was going up!” The story on the other hand that I have been telling for quite some time (and which I write about in my book) is that it’s partly because the Fed is tightening and interest rates are going up that that inflation is rising, in a feedback loop that is missed in our popular stories. The important part is the next chapter in the story. In the “Fed is getting ahead of it” story, inflation comes down and the Fed is able to stop tightening, achieving a soft landing. In the “rate increase is causing velocity to rise and inflation to rise” story, the Fed keeps chasing the dog which is only running because the Fed is chasing it.

There is another alternative, which really excites the stock market as evidenced by today’s massive – although disturbingly low-volume – rally. That story is that the Fed is going to become more “data dependent” (Chairman Powell suggested something along these lines today), which is great because the Fed has already won on inflation and growth is still okay. So the Fed can stop the autopilot rate hikes. This story unfortunately does require a little suspension of disbelief. For one thing, today’s strong Employment report (Payrolls 370k, including revisions, compared to 184k expectations) is unfortunately a December figure which means it has huge error bars. Moreover, the Unemployment Rate rose to 3.9% from 3.7%, and while a higher Unemployment Rate doesn’t mean the economy is definitely slowing (it could just be that more people are looking for jobs because the job market is so robust – another fun story), it is certainly more consistent with the notion that the economy is slowing at the margin. The fact that the Unemployment Rate went up, while Hourly Earnings rose more than expected and Jobs rose more than expected, should make you suspect that year-end quirkiness might have something to do with the figures. For the decades I’ve watched economic data, I always advise ignoring the January and February Employment Reports since the December/January changes in payroll are so large that the noise swamps the signal. But professional storytellers aren’t really content to say “this doesn’t really mean anything,” even if that’s the quantitative reality. They get paid to spin yarns, so spin yarns they do.

Yeah, about those wages: I’m not really sure why economists were expecting hourly earnings to decelerate this month. All of the anecdotal data, along with other wage measures, are suggesting that wages are rising apace (see chart, source Bloomberg, showing the Atlanta Fed Wage Tracker vs AHE). Not really a surprise, even given its compositional challenges, that AHE is also rising.

The thing about all of these stories is that while they can’t change the actual reality, they can change how reality is priced. This is one of the reasons that we get bubbles. The stories are so powerful that trading against them, with a ‘value’ mindset for example, is quixotic. Ultimately, in the long run, the value of the equity market is limited by fundamentals. But in the short run, it is virtually unlimited because of valuation multiples (price as a speculative multiple of fundamental earnings, e.g.) and those valuation multiples are driven by stories. And that’s a big reason that bullish stories are so popular.

But consider this bearish footnote on today’s 3.4% S&P rally: volume in the S&P constituents today was lower than the volume was on December 26! To be fair, the volume yesterday, when the S&P declined 2.5%, was even a bit lower than today’s volume. It’s typical thin and whippy first-week-of-the-year trading. Let’s see what next week brings.


[1] People occasionally ask me why I didn’t go on for my MA or PhD in Economics. I reply that it’s because I learned my Intermediate Microeconomics very well: I stopped going for a higher degree when the marginal costs outweighed the marginal benefits. When you look at it that way, it makes you wonder whether the PhD economists aren’t just the bad students who didn’t absorb that lesson.

[2] It’s referred to as the “price puzzle”; see Martin Eichenbaum, “Interpreting Macroeconomic Time Series Facts: The Effects of Monetary Policy: Comments.” European Economic Review, June 1992. And Michael Hanson, “The ‘Price Puzzle’ Reconsidered,” Journal of Monetary Economics, October 2004.

Summary of My Post-CPI Tweets (December 2018)

December 12, 2018 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 or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • Been a while since I did a live CPI dive here. Thanks to all of those who voted with their dollars over the last year and supported my private CPI tweets. It wasn’t enough to make a commitment to it, so I’m back to occasionally doing it free on this channel. Hope it helps.
  • I do it anyway for myself and Enduring Investments, so it’s not THAT big a deal to put it here if I happen to be in the mood. Anyway, hope you get some value. If so, think about whether I or Enduring can help your investment processes. Now for the walk-up.
  • Consensus calls for about 0.18% on core CPI today, with the y/y rising to 2.2%. The bouncy PPI helps the mood although the PPI itself doesn’t have much forecasting power for CPI.
  • in PPI there were clear freight and other upstream pressures though. We haven’t really seen much of this in CPI – no real trade/tariff effect yet e.g. Apparel is where I’d expect to see than and in core goods generally. But they’re still slightly in deflation.
  • I think there’s some upward risk to used cars and trucks, but there was a big jump last month so we could get a retracement of that before another move higher next month, or continue the ‘catch up’ to private surveys this month. Hard to tell on a month-to-month basis.
  • Lodging Away from Home took a dip last month and might be upside risk today. Medical Care is due to start rising again too. So in a minute, we will see!
  • Slightly stronger core than expected…0.21% when they were looking for 0.18%. But pretty close.

  • 21% on NSA core y/y.
  • Let’s see. Core goods went up to 0.0% y/y from -0.1%, so that’s moving in the expected direction. Another big month from Used Cars and Trucks, +2.37% m/m after +2.62% last month. y/y now up to 2.30%. It was negative just a few months ago.

  • Lodging Away from Home rose from -2.42% y/y to -1.38% y/y, as we got a small positive this month after a big negative last month. I’m still skeptical that hotel prices are in deflation but someone will yell “AIRBNB” loud enough like that’s an argument, so I’ll leave it there.
  • Hefty lift in Primary Rents. +0.36% m/m, bringing y/y to 3.61% from 3.57%. That’s news because lots of pundits have been decrying the end of the housing market and therefore housing inflation. These aren’t necessarily the same thing.
  • Apparel actually took another large fall m/m. This continues to make little sense in a tariffy world.

  • Some of that is dollar strength, sure. But I’m still surprised.
  • Medical was +0.37% m/m after -0.07%, so that came through as I expected/hoped. Y/y rose to 2.03% vs 1.71%. Both Pharma and Doctor’s Services rose nearly 0.5% m/m after declines last month. Interesting that despite this, and housing, core services were unch at 2.9% y/y.
  • Core inflation, ex-shelter rose to 1.53%, almost at the 2016 highs (1.61%). The disinflationary impulses are deep in the rear-view mirror now.

  • The Apparel breakdown is always so weird. Y/Y, “Boys’ apparel” is +11.9% while “Girls’ apparel” is -0.7%. Hokay.
  • Brace yourself for a big jump in Median. Looks like the median category is a housing subindex so my estimate won’t necessarily be accurate but it won’t be LOWER than 0.28% m/m and my best guess is 0.33% m/m pushing y/y median CPI to 2.83%. Won’t know for a few hours yet.
  • 83% if it happened would be basically back to the highs. So the question is, what’s keep Core Services from a bigger bounce if housing and medical care are both looking strong?
  • Motor Vehicle Insurance? This is 2.4% of CPI.

  • Health insurance rising again…we knew this was true on the wholesale level but seems to be coming thru retail as well. But CPI measures health insurance inflation in an odd way, too much to get into here.

  • Oh no. Are you kidding me? Wireless telephone services -3% y/y down from -0.5%y/y last month. *smh* Here we go again?

  • Currently triumph of hope over experience in stocks. This figure clearly puts the Fed squarely still in tightening mode. And I don’t expect any major easing of inflationary pressures soon.
  • Kind of a good reminder of how out over their skis the inflation shorts are here. With Median at 2.7% or 2.8% after today, here’s the core cpi curve from inflation swaps (calculated by Enduring Investments). X-axis is years. Tremendous confidence that the Fed will win.

  • Now, to be sure the hurdles for y/y core get higher over the next few months, with Dec ’17 at +0.24% m/m and Jan ’18 at +0.35% (remember that??), so core will probably not reach new highs until Q2. But there’s nothing here to give confidence that inflation is about to fall.
  • Let’s do the four pieces. For new followers, these four pieces are each roughly a quarter (0.2%-0.3%) of CPI. The first and most volatile is Food & Energy. We don’t spend a lot of time on this. No forecasting power.

  • Piece 2 is core goods, the smallest of these 4 pieces but the main thing that has kept inflation sedated over last half decade. Now out of deflation even with a strong dollar. Sustainable? In a de-coupling world, maybe.

  • Core services, less rent of shelter. long downtrend still in place. This includes stuff like medical care, but also wireless services. Which really ought to have its own category I’m starting to think!

  • Steadiest piece is Rent of Shelter. This is just coming back to model. No real upstream signs that this is about to roll over – it was just ahead of itself. Latest point is actually an up-wiggle.

  • One more chart. The weight of the distribution of y/y changes. You can see the big bars for housing but the long tail. The bar at left is mostly food, energy, tech, and apparel at the moment. Without those categories, CPI is around 2.8%, right around median.

No real reason to wrap this one up – the numbers speak for themselves. Despite the weakness in energy, which is killing the inflation markets (since energy is most of the volatility in headline inflation, to which TIPS and inflation swaps are tied), prices in general continue to rise and if anything seem to be gaining a little steam even outside of housing. Housing inflation isn’t likely to move very far in either direction for a while from the current level, so the next movement in core or median CPI is going to come from core-ex-shelter categories like Medical Care (possibly looking up), Apparel (quite heavy), and other core goods like autos.

But there’s no reason whatsoever in these numbers to indicate to the Federal Reserve that it’s time to stop raising rates. To the extent that they begin to chirp about a pause, it’s because they want stock prices to go up (or, I guess, more accurately they just don’t want to be blamed for the bear market). Yes, growth is slowing but no formulation of the Taylor Rule is going to give a lot of cover to a decision to ease off of rate hikes when the policy rate is below the current rate of inflation.

The Neatest Idea Ever for Reducing the Fed’s Balance Sheet

September 19, 2018 14 comments

I mentioned a week and a half ago that I’d had a “really cool” idea that I had mentioned to a member of the Fed’s Open Market Desk, and I promised to write about it soon. “It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.” First, some background.

It is currently not possible to directly access any inflation index other than headline inflation (in any country that has inflation-linked bonds, aka ILBs). Yet, many of the concerns that people have do not involve general inflation, of the sort that describes increases in the cost of living and erodes real investment returns (hint – people should care, more than they do, about inflation), but about more precise exposures. For examples, many parents care greatly about the inflation in the price of college tuition, which is why we developed a college tuition inflation proxy hedge which S&P launched last year as the “S&P Target Tuition Inflation Index.” But so far, that’s really the only subcomponent you can easily access (or will, once someone launches an investment product tied to the index), and it is only an approximate hedge.

This lack has been apparent since literally the beginning. CPI inflation derivatives started trading in 2003 (I traded the first USCPI swap in the interbank broker market), and in February 2004 I gave a speech at a Barclays inflation conference promising that inflation components would be tradeable in five years.

I just didn’t say five years from when.

We’ve made little progress since then, although not for lack of trying. Wall Street can’t handle the “basis risks,” management of which are a bad use of capital for banks. Another possible approach involves mimicking the way that TIGRs (and CATS and LIONs), the precursors to the Treasury’s STRIPS program, allowed investors to access Treasury bonds in a zero coupon form even though the Treasury didn’t issue zero coupon bonds. With the TIGR program, Merrill Lynch would put normal Treasury bonds into a trust and then issue receipts that entitled the buyer to particular cash flows of that bond. The sum of all of the receipts equaled the bond, and the trust simply allowed Merrill to disperse the ownership of particular cash flows. In 1986, the Treasury wised up and realized that they could issue separate CUSIPs for each cash flow and make them naturally strippable, and TIGRs were no longer necessary.

A similar approach was used with CDOs (Collateralized Debt Obligations). A collection of corporate bonds was put into a trust[1], and certificates issued that entitled the buyer to the first X% of the cash flows, the next Y%, and so on until 100% of the cash flows were accounted for. Since the security at the top of the ‘waterfall’ got paid off first, it had a very good rating since even if some of the securities in the trust went bust, that wouldn’t affect the top tranche. The next tranche was lower-rated and higher-yielding, and so on. It turns out that with some (as it happens, somewhat heroic) assumptions about the lack of correlation of credit defaults, such a CDO would produce a very large AAA-rated piece, a somewhat smaller AA-rated piece, and only a small amount of sludge at the bottom.

So, in 2004 I thought “why don’t we do this for TIPS? Only the coupons would be tied to particular subcomponents. If I have 100% CPI, that’s really 42% housing, 3% Apparel, 9% Medical, and so on, adding up to 100%. We will call them ‘Barclays Real Accreting-Inflation Notes,’ or ‘BRAINs’, so that I can hear salespeople tell their clients that they need to get some BRAINs.” A chart of what that would look like appears below. Before reading onward, see if you can figure out why we never had BRAINs.

When I was discussing CDOs above, you may notice that the largest piece was the AAA piece, which was a really popular piece, and the sludge was a really small piece at the bottom. So the bank would find someone who would buy the sludge, and once they found someone who wanted that risk they could quickly put the rest of the structure together and sell the pieces that were in high-demand. But with BRAINs, the most valuable pieces were things like Education, and Medical Care…pretty small pieces, and the sludge was “Food and Beverages” or “Transportation” or, heaven forbid, “Other goods and services.” When you create this structure, you first need to find someone who wants to buy a bunch of big boring pieces so you can sell the small exciting pieces. That’s a lot harder. And if you don’t do that, the bank ends up holding Recreation inflation, and they don’t really enjoy eating BRAINs. Even the zombie banks.

Now we get to the really cool part.

So the Fed holds about $115.6 billion TIPS, along with trillions of other Treasury securities. And they really can’t sell these securities to reduce their balance sheet, because it would completely crater the market. Although the Fed makes brave noises about how they know they can sell these securities and it really wouldn’t hurt the market, they just have decided they don’t want to…we all know that’s baloney. The whole reason that no one really objected to QE2 and QE3 was that the Fed said it was only temporary, after all…

So here’s the idea. The Fed can’t sell $115bln of TIPS because it would crush the market. But they could easily sell $115bln of BRAINs (I guess Barclays wouldn’t be involved, which is sad, because the Fed as issuer makes this FRAINs, which makes no sense), and if they ended up holding “Other Goods and Services” would they really care? The basis risk that a bank hates is nothing to the Fed, and the Fed need hold no capital against the tracking error. But if they were able to distribute, say, 60% of these securities they would have shrunk the balance sheet by about $70 billion…and not only would this probably not affect the TIPS market – Apparel inflation isn’t really a good substitute for headline CPI – it would likely have the large positive effect of jump-starting a really important market: the market for inflation subcomponents.

And all I ask is a single basis point for the idea!


[1] This was eventually done through derivatives with no explicit trust needed…and I mean that in the totally ironic way that you could read it.

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