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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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Inflation-Related Impressions from Recent Events

September 10, 2018 2 comments

It has been a long time since I’ve posted, and in the meantime the topics to cover have been stacking up. My lack of writing has certainly not been for lack of topics but rather for a lack of time. So: heartfelt apologies that this article will feel a lot like a brain dump.

A lot of what I want to write about today was provoked/involves last week. But one item I wanted to quickly point out is more stale than that and yet worth pointing out. It seems astounding, but in early August Japan’s Ministry of Health, Labour, and Welfare reported the largest nominal wage increase in 1997. (See chart, source Bloomberg). This month there was a correction, but the trend does appear firmly upward. This is a good point for me to add the reminder that wages tend to follow inflation rather than lead it. But I believe Japanese JGBis are a tremendous long-tail opportunity, priced with almost no inflation implied in the price…but if there is any developed country with a potential long-tail inflation outcome that’s possible, it is Japan. I think, in fact, that if you asked me to pick one developed country that would be the first to have “uncomfortable” levels of inflation, it would be Japan. So dramatically out-of-consensus numbers like these wage figures ought to be filed away mentally.

While readers are still reeling from the fact that I just said that Japan is going to be the first country that has uncomfortable inflation, let me talk about last week. I had four inflation-related appearances on the holiday-shortened week (! is that an indicator? A contrary indicator?), but two that I want to take special note of. The first of these was a segment on Bloomberg in which we talked about how to hedge college tuition inflation and about the S&P Target Tuition Inflation Index (which my company Enduring Investments designed). I think the opportunity to hedge this specific risk, and to create products that help people hedge their exposure to higher tuition costs, is hugely important and my company continues to work to figure out the best way and the best partner with whom to deploy such an investment product. The Bloomberg piece is a very good segment.

I spent most of Wednesday at the Real Return XII conference organized by Euromoney Conferences (who also published one of my articles about real assets, in a nice glossy form). I think this is the longest continually-running inflation conference in the US and it’s always nice to see old friends from the inflation world. Here are a couple of quick impressions from the conference:

  • There were a couple of large hedge funds in attendance. But they seem to be looking at the inflation markets as a place they can make macro bets, not one where they can take advantage of the massive mispricings. That’s good news for the rest of us.
  • St. Louis Fed President James Bullard gave a speech about the outlook for inflation. What really stood out for me is that he, and the Fed in general, put enormous faith in market signals. The fact that inflation breakevens haven’t broken to new highs recently carried a lot of weight with Dr. Bullard, for example. I find it incredible that the Fed is actually looking to fixed-income markets for information – the same fixed-income markets that have been completely polluted by the Fed’s dominating of the float. In what way are breakevens being established in a free market when the Treasury owns trillions of the bonds??
  • Bullard is much more concerned about recession than inflation. The fact that they can both occur simultaneously is not something that carries any weight at the Fed – their models simply can’t produce such an outcome. Oddly, on the same day Neel Kashkari said in an interview “We say that we have a symmetric view of inflation. We don’t mind if it’s 2.1 or 1.9, but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.” That’s ludicrous, by the way – there is no way in the world that the Fed would have done the second and third QEs, with the recession far in the rear view mirror, if the Fed was more concerned with high inflation. Certainly, Bullard showed no signs of even the slightest concern that inflation would poke much above 2%, much less 3%.
  • In general, the economists at the conference – remember, this is a conference for people involved in inflation markets – were uniform in their expectation that inflation is going nowhere fast. I heard demographics blamed (although current demographics, indicating a leftward shift of the supply curve, are actually inflationary it is a point of faith among some economists that inflation drops when the number of workers declines. It’s actually a Marxist view of the economic cycle but I don’t think they see it that way). I heard technology blamed, even though there’s nothing particularly modern about technological advance. Economists speaking at the conference were of the opinion that the current trade war would cause a one-time increase in inflation of between 0.2%-0.4% (depending on who was speaking), which would then pass out of the data, and thought the bigger effect was recessionary and would push inflation lower. Where did these people learn economics? “Comparative advantage” and the gain from trade is, I suppose, somewhat new…some guy named David Ricardo more than two centuries ago developed the idea, if I recall correctly…so perhaps they don’t understand that the loss from trade is a real thing, and not just a growth thing. Finally, a phrase I heard several times was “the Fed will not let inflation get out of hand.” This platitude was uttered without any apparent irony deriving from the fact that the Fed has been trying to push inflation up for a decade and has been unable to do so, but the speakers are assuming the same Fed can make inflation stick at the target like an arrow quivering in the bullseye once it reaches the target as if fired by some dead-eye monetary Robin Hood. Um, maybe.
  • I marveled at the apparent unanimity of this conclusion despite the fact that these economists were surely employing different models. But then I think I hit on the reason why. If you built any economic model in the last two decades, a key characteristic of the model had to be that it predicted inflation would be very low and very stable no matter what other characteristics it had. If it had that prediction as an output, then it perfectly predicted the last quarter-century. It’s like designing a technical trading model: if you design one that had you ‘out’ of the 1987 stock market crash, even if it was because of the phase of the moon or the number of times the word “chocolate” appeared in the New York Times, then your trading model looks better than one that doesn’t include that “factor.” I think all mainstream economists today are using models that have essentially been trained on dimensionless inflation data. That doesn’t make them good – it means they have almost no predictive power when it comes to inflation.

This article is already getting long, so I am going to leave out for now the idea I mentioned to someone who works for the Fed’s Open Market Desk. But it’s really cool and I’ll write about it at some point 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.

So I’ll move past last week and close with one final off-the-wall observation. I was poking around in Chinese commodity futures markets today because someone asked me to design a trading strategy for them (don’t ask). I didn’t even know there was such a thing as PVC futures! And Hot Rolled Coils! But one chart really struck me:

This is a chart of PTA, or Purified Terephthalic Acid. What the heck is that? PTA is an organic commodity chemical, mainly used to make polyester PET, which is in turn used to make clothing and plastic bottles. Yeah, I didn’t know that either. Here’s what else I don’t know: I don’t know why the price of PTA rose 50% in less than two months. And I don’t know whether it is used in large enough quantities to affect the end price of apparel or plastic bottles. But it’s a pretty interesting chart, and something to file away just in case we start to see something odd in apparel prices.

Let me conclude by apologizing again for the disjointed nature of this article. But I feel better for having burped some of these thoughts out there and I hope you enjoyed the burp as well.

Summary of My Post-CPI Tweets (August 2018)

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

  • half hour to CPI. Welcome again to the private channel. Tell your friends!
  • Another easy comp (0.143%) versus year ago. August 2017 was +0.222%, Sep was 0.132%, Oct was 0.214%, and Nov was 0.121%. So we still have some easy comps ahead although not easy as they were. That means core should keep rising, although slower than over the last 6 mo.
  • Pretty safe economist estimate for 0.2% on core and for y/y to stay 2.3% rounded. As long as m/m core is 0.162%-0.259%, y/y will stay in that range.
  • Rents have been leveling out recently, and not providing as much upward oomph. That passes the baton to core goods and more generally to core ex-shelter.
  • Ironically, even though core goods started to accelerate before any sign of tariffs, investors I think might “look through” inflation like that, which they can explain away by saying “ha ha tariffs trump ha ha.”
  • One other item – I will be especially attentive to Median CPI this month, which jumped to 2.80% y/y last month. That looks a little like an acceleration past the prior trend (meaning 2013-2015), well past merely erasing the 2016-17 dip.
  • I should note that this month’s CPI report is being brought to you from sunny Curacao! Only 20 minutes to the number.
  • Well, 0.23% on core CPI was a bit higher than expected, but oddly got a tick higher in the y/y to 2.354%, rounding up to 2.4%. The SA y/y is still 2.3%, but NSA is 2.4%. This happens from time to time because seasonal factors change year to year.
  • Last 12 Rorschach test.

  • CPI – Used Cars and Trucks +1.31% m/m, pushing y/y to 0.84% y/y FINALLY. Private surveys have been saying this for a while.
  • Owners’ Equivalent Rent +0.29% (3.395% y/y), up from 3.37%, and primary rents +0.32% to 3.628%, up from 3.58% last month. Lodging away from home +0.4% m/m after -3.7% last month, so some give-back.
  • Core goods back to 0% y/y, first time in 5 years it has been out of deflation!
  • A fair amount of that is cars.

  • But not all is upbeat. Interestingly core services was steady at 3.1% even though Medical Care was weak across the board. Overall Med Care -0.2% m/m, making y/y 1.91% vs 2.45% last month. Pharma -0.96% m/m, 0.92% y/y vs 3.19% last month. Doctors svcs -0.17%/0.64% vs 0.86%
  • …and hospital services 0.36% m/m, 4.59% y/y, vs 4.74% last month.
  • used car chart update.

  • Not much market reaction. It is after all August. 10y breakevens up about 0.5bps from just before the figure. I think for the “look through the number” people the jump in cars is going to scream “steel tariffs” even though I think it’s more.
  • New cars y/y.

  • core ex-shelter now at 1.50%, the highest in 2 years. Inflation isn’t just in housing any more.
  • Biggest m/m declines were two apparel categories (which move around a lot) and Medical Care Commodities. Biggest gainers Public Transport, Car/Truck Rental, Jewelry/Watches, Fresh Fruits/Veggies, and Used Cars & Trucks.
  • My estimate of Median CPI is 0.224%, pushing y/y to 2.84%. Getting perilously close to 3%!
  • Four pieces: food & energy

  • Core goods – it has been a long time since core goods was meaningfully above 0%. It will happen.

 

  • Core services less Rent of Shelter. This is interesting because Medical Care Services is a big part of this and it was weak. But Core Services didn’t soften.

  • Piece 4: Rent of Shelter. Stable, high. No real chance for this to substantially slow in the near term.

 

  • I think we’ll stop there for today. All in all an interesting report as core goods is starting to show some worrying strength and core inflation outside of shelter is now getting perky too.

Really, the only important softness in this report was medical care. A lot of that was pharmaceuticals (which is in core goods), and yet core goods still accelerated to flat for the last year. But the core services part of medical care also decelerated, and core services overall didn’t drop. The weakness in medical care matters because PCE – which the Fed uses as its benchmark – exaggerates the importance of medical care so this trend will tend to keep core PCE lower relative to core CPI, and help the Fed believe they are not “behind the curve.” Yet, there are some signs that even dovish FRB members are not wholly on board with that any longer; nor should they be. For a long time, shelter has been the driving force pushing core inflation higher but that is no longer the case. The rise in core-ex-shelter to 1.5%, and the fact that core goods is about to lurch into positive territory, are both contributing to the broadening inflation trend. We see this in median inflation, which should rise again to a further post-crisis high when it is reported in a few hours.

We alternate between modest comps and easy comps for the next few months – but no really difficult comps. Measured inflation should continue to accelerate for the balance of 2018 and make the Fed’s obsession with core PCE increasingly indefensible.

A Real Concern About Over(h)eating

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

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

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

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

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

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

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

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

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

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


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

Summary of My Post-CPI Tweets (June 2018)

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, by going to PremoSocial. Until the end of June, you can get $9.99 off (one month free, or a discount off the already-discounted annual plan) by using code “tryme”. Or, sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

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

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

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

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

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

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

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

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

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

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

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

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

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

Why the M2 Slowdown Doesn’t Blunt My Inflation Concern

April 12, 2018 1 comment

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Summary of My Post-CPI Tweets (Apr 2018)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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