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Drug Prices and Most-Favored-Nation Clauses: Considerations

August 25, 2020 4 comments

A potentially important development in the market for pharmaceuticals – and in the pricing of the 1.6% of the Consumer Price Index that Medicinal Drugs represents – is the President’s move towards a “most-favored-nation” clause in the pricing of pharmaceuticals. The concept of a favored-nations clause is not new, although this is the first time it has been applied broadly to the pharmaceutical industry. In the investment management industry, it is not uncommon for very large investors (state pension funds, for example) to demand such a clause in their investment management agreements. Essentially, what such a clause does is guarantee to the customer that no other customer will get better pricing.[1] In the context of pharmaceuticals, the “problem” that the President is addressing is the fact that Americans buying a drug will often pay many times what a customer in another country will pay the pharmaceutical company for that same drug.

The optics are terrific for the President, but the economics not as much so. The argument is that demanding such a clause will force pharmaceutical companies to lower prices for American consumers drastically, to something approximating the price of those same products purchased abroad. The reality, though, is not so clear.

This is a story about price elasticity of demand. As I do often, I pause here and give thanks that I studied economics at a university that had a fantastic econ faculty. Economics is a great field of study, because done right it teaches a person to ask the right questions rather than jumping to what seems to be the apparent answer. (Incidentally, I feel the same way about Street research: done right, the value of that research is in guiding the questions, rather than handing us the answers.)

So let’s start at the ‘free market’ version of the pharmaceutical company’s profit-maximization problem. Let’s start by assuming that the marginal cost of production of a little pill is close to zero, or at least that it’s no different for the pill sold in one country versus the pill sold in another country. Then, the firm’s profit-maximizing linear programming problem is to maximize, independently for each country, the price where the marginal revenue is essentially zero – where in order to sell additional units, the price must be lowered enough that selling those additional units costs more in lost profit on the other units than it does on the incremental units. (If I sell 10 units at $10, and in order to sell the 11th unit I have to lower the price to $9, then I go from $100 in revenue to $99 in revenue and so if I am a profit-maximizer I won’t do this).

This point will be different in each country, and depends on the demand elasticity for that drug in that country. If the demand for a drug is very elastic, then that market will tend to clear at a lower price since each incremental decline in price will produce a relatively large increase in incremental quantity demanded. On the other hand, if the demand for the drug is very inelastic, then that market will tend to clear at a higher price since each additional increase in price will result in the loss of relatively few units of quantity sold. Now, every country and every drug will have different price elasticities. A lifestyle drug like the little blue pill will face fairly elastic demand in a Third World country, while a malarial drug probably does not.[2]

As an aside, one of the things which creates a more-elastic demand curve is the availability of substitutes. So, if the FDA makes it more difficult for a new statin drug to be approved than does the equivalent agency in Italy, then demand for a particular statin drug (all else equal) will be more elastic in Italy, where it faces more competition, than in the US. If you want lower prices, promote competition. But back to our story:

Now the Trump Administration adds a constraint to the drug company’s linear programming problem, such that the maximization is now joint; the problems are no longer independent maximization problems but the company must find the price that maximizes revenue across all markets collectively. If the free market has found a perfect and efficient equilibrium, then any such constraint must lower the value of the revenue stream to the drug company because if it did not, then it implies the company would already have be operating at that single-price solution. Constrained solutions can never be more valuable than unconstrained solutions, if both are in equilibrium.

What the drug company most assuredly will not do, though, is immediately lower the price to the American consumer to the lowest price charged to any other country. What it will do instead is take the highest price, and then add the incremental market that has the most inelastic demand, and see how much total revenue will increase if they have to lower the universal price to induce demand in that market. Note that this outcome may lower the price in the high-priced country, but it will also raise the price in the low-priced country. Since the lower-priced countries probably have more-elastic demand than the high-priced country…which is suggested by the fact that they had lower prices when they were being separately optimized…it is easy to imagine a scenario where the drug company ends up only supplying the high-priced country because the large increases in price for other countries essentially eliminate that demand. And that outcome, or indeed as I said any constrained outcome, is likely to be bad for the drug company. But what it will almost certainly not do is cause drug prices in the USA to drop 70%, or a massive decline in the Medicinal Drugs portion of CPI.

It may cause a decline in US drug prices, but that is not as certain as it appears. If the optimal strategy is to supply the drug only in the United States, then prices need not change at all (the US would then be the Most Favored Nation because it’s the only customer). In fact, the drug company might need to increase prices in the US. That happens because when you allow price discrimination, any customer who pays more than the variable cost of the product (which we assume here is close to zero) contributes something to the fixed overhead of the company;[3] therefore, a company that understands cost accounting will sometimes sell a product below the total cost per unit as long as it is above the variable cost per unit. When a US company, then, sells a pill to Norway at a really low price but above the cost of production, it defrays some of its overhead. If a most-favored-nation clause prevents a company from doing this, it will need to raise the price of the product in its remaining markets in order to cover the overhead that is not being covered any longer by those customers.

OK, so that’s just one iteration. I suspect that most pharmaceutical companies will end up lowering prices a little bit in the US and in other countries where prices are similar, and only selling them in countries that now pay a very low price to the extent that those foreign countries and/or international charities subsidize those purchases. But then we get into the financial and legal engineering part of this: what happens if Pfizer now licenses the formula for a particular drug to an Indian company that is legally distinct and doesn’t sell to the United States? Does the licensing agreement also fall under the MFN clause? What if Pfizer spins off its South American operations, sharing the intellectual property with its spinoff? For that matter, it might be the case that for some drugs, it is optimal to sell it everywhere in the world except the US, because the value of the unconstrained-non-US portion of the business is greater than the constrained-US portion of the business.

Now wouldn’t that be a kick in the head, to see pharmaceutical companies leave the US and refuse to sell to the US consumer because it makes them subject to the MFN clause? In the end, it seems to me that this is a great political gesture but it will be very difficult to get the results the President and his team wants.


[1] As an aside, in investment management this has caused the universe of strategies available to institutions demanding this clause to be reduced, hurting their investors. There are many circumstances in which an investment manager will offer outstanding, and sometimes outlandish, terms to investors who are the first in a new strategy, or who are low-touch easy/sophisticated customers, etc; a later entry by a large, high-maintenance customer may not be economic under the same terms.

[2] I am not at all an expert on how drug price elasticity behaves in this riot of market/product combinations, so readers who are should give me a break! I’m just illustrating a point.

[3] Cleverly called “variable contribution.”

COVID-19 in China is a Supply Shock to the World

February 25, 2020 2 comments

The reaction of much of the financial media to the virtual shutdown of large swaths of Chinese production has been interesting. The initial reaction, not terribly surprising, was to shrug and say that the COVID-19 virus epidemic would probably not amount to much in the big scheme of things, and therefore no threat to economic growth (or, Heaven forbid, the markets. The mere suggestion that stocks might decline positively gives me the vapors!) Then this chart made the rounds on Friday…

…and suddenly, it seemed that maybe there was something worth being concerned about. Equity markets had a serious slump yesterday, but I’m not here to talk about whether this means it is time to buy TSLA (after all, isn’t it always time to buy Tesla? Or so they say), but to talk about the other common belief and that is that having China shuttered for the better part of a quarter is deflationary. My tweet on the subject was, surprisingly, one of my most-engaging posts in a very long time.

The reason this distinction between “supply shock” and “demand shock” is important is that the effects on prices are very different. The first stylistic depiction below shows a demand shock; the second shows a supply shock. In the first case, demand moves from D to D’ against a stable supply curve S; in the latter case, supply moves from S to S’ against a stable demand curve D.

Note that in both cases, the quantity demanded (Q axis) declines from c to d. Both (negative) demand and supply shocks are negative for growth. However, in the case of a negative demand shock, prices fall from a to b; in the case of a negative supply shock prices rise from a to b.

Of course, in this case there are both demand and supply shocks going on. China is, after all, a huge consumption engine (although a fraction of US consumption). So the growth picture is unambiguous: Chinese growth is going to be seriously impacted by the virtual shutdown of Wuhan and the surrounding province, as well as some ports and lots of other ancillary things that outsiders are not privy to. But what about the price picture? The demand shock is pushing prices down, and the supply shock is pushing them up. Which matters more?

The answer is not so neat and clean, but it is neater and cleaner than you think. Is China’s importance to the global economy more because of its consumption, as a destination for goods and services? Or is it more because of its production, as a source of goods and services? Well, in 2018 (source: Worldbank.org) China’s exports amounted to about $2.5trillion in USD, versus imports of $2.1trillion. So, as a first cut – if China completely vanished from global trade, it would amount to a net $400bln in lost supply. It is a supply shock.

When you look deeper, there is of course more complexity. Of China’s imports, about $239bln is petroleum. So if China vanished from global trade, it would be a demand shock in petroleum of $240bln (about 13mbpd, so huge), but a bigger supply shock on everything else, of $639bln. Again, it is a supply shock, at least ex-energy.

And even deeper, the picture is really interesting and really clear. From the same Worldbank source:

China is a huge net importer of raw goods (a large part of that is energy), roughly flat on intermediate goods, and a huge net exporter of consumer and capital goods. China Inc is an apt name – as a country, she takes in raw goods, processes them, and sells them. So, if China were to suddenly vanish, we would expect to see a major demand shock in raw materials and a major supply shock in finished goods.

The effects naturally vary with the specific product. Some places we might expect to see significant price pressures are in pharmaceuticals, for example, where China is a critical source of active pharmaceutical ingredients and many drugs including about 80% of the US consumption of antibiotics. On the other hand, energy prices are under downward price pressure as are many industrial materials. Since these prices are most immediately visible (they are commodities, after all), it is natural for the knee-jerk reaction of investors to be “this is a demand shock.” Plus, as I said in the tweet, it has been a long time since we have seen a serious supply shock. But after the demand shock in raw goods (and possibly showing in PPI?), do not be surprised to see an impact on the prices of consumer goods especially if China remains shuttered for a long time. Interestingly, the inflation markets are semi-efficiently pricing this. The chart below is the 1-year inflation swap rate, after stripping out the energy effect (source: Enduring Investments). Overall it is too low – core inflation is already well above this level and likely to remain so – but the recent move has been to higher implied core inflation, not lower.

Now, if COVID-19 blossoms into a true global contagion that collapses demand in developed countries – especially in the US – then the answer is different and much more along the lines of a demand shock. But I also think that, even if this global health threat retreats, real damage has been done to the status of China as the world’s supplier. Although it is less sexy, less scary, and slower, de-globalization of trade (for example, the US repatriating pharmaceuticals production to the US, or other manufacturers pulling back supply chains to produce more in the NAFTA bloc) is also a supply shock.

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

October 31, 2019 14 comments

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

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

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

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

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

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

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

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

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

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

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


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

Tariffs Don’t Hurt Domestic Growth

August 28, 2019 7 comments

I really wish that economics was an educational requirement in high school. It doesn’t have to be advanced economics – just a class covering the basics of micro- and macroeconomics so that everyone has at least a basic understanding of how an economy works.

If we had that, perhaps the pernicious confusion about the impact of tariffs wouldn’t be so widespread. It has really gotten ridiculous: on virtually any news program today, as well as quite a few opinion programs (and sometimes, it is hard to tell the difference), one can hear about how “the trade war is hurting the economy and could cause a recession.” But that’s ridiculous, and betrays a fundamental misunderstanding about what tariffs and trade barriers do, and what they don’t do.

Because to the extent that people remember anything they were taught about tariffs (and here perhaps we run into the main problem – not that we weren’t taught economics, but that people didn’t think it was important enough to remember the fine points), they remember “tariffs = bad.” Therefore, when tariffs are implemented or raised, and something bad happens, the unsophisticated observer concludes “that must be because of the tariffs, because tariffs are bad.” In the category of “unsophisticated observer” here I unfortunately have to include almost all journalists, most politicians, and most alarmingly a fair number of economists and members of the Fed. Although, to be fair, I don’t think the latter two groups are making the same error as the former groups; they’re probably just confusing the short-term and the long-term or thinking globally rather than locally.

In any event, this reached a high enough level of annoyance for me that I felt the need to write this short column about the effects of tariffs. I actually wrote some of this back in June but needed to let it out again.

The effect of free trade, per Ricardo, is to enlarge the global economic pie. (Ricardo didn’t speak in terms of pie, but if he did then maybe people would understand this better.) However, in choosing free trade to enlarge the pie, each participating country surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off.

However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the US went through a period of truly sucking at automobile manufacturing, we still have the big three automakers. On the other hand, the US no longer produces any apparel to speak of. In fact, I would suggest that the only way that free trade works at all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself. Many would argue that (b) is what happened, as the US was willing to let its manufacturing be ‘hollowed out’ in order to make the world a happier place on average. Enter President Trump, who suggested that as US President, it was sort of his job to look out for US interests. And so we have tariffs and a trade war.

What is the effect of tariffs?

  1. Tariffs are good for the domestic growth of the country imposing them. There is no question about it in a static equilibrium world: if you raise the price of the overseas competitor, then your domestic product will be relatively more attractive and you will be asked to make more of it. If other countries respond, then the question of whether it is good or bad for growth depends on whether you are a net importer or exporter, and on the relative size of the Ex-Im sector of your economy. The US is a net importer, which means that even if other countries respond equally it is still a gain…but in any event, the US economy is relatively closed so retaliatory tariffs have a comparatively small effect. The effect is clearly uneven, as some industries benefit and some lose, but tariffs are a net gain to growth for the US in the short term (at least).
  2. Tariffs therefore are good for US employment. In terms of both growth and employment, recent weakness has been blamed on tariffs and the trade war. But this is nonsense. The US economy and the global economy have cycles whether or not there is a trade war, and we were long overdue for a slowdown. The fact that growth is slowing at roughly the same time tariffs have been imposed is a correlation without causality. The tariffs are supporting growth in the US, which is why Germany is in a recession and the US is not (yet). Anyone who is involved with a manufacturing enterprise is aware of this. (I work with one manufacturer which has suddenly started winning back business that had previously been lost to China in a big way).
  3. Tariffs are bad for global growth. The US-led trade war produces a shrinkage of the global pie (well, at least a slowing of its growth) even as the US slice gets relatively larger. But for countries with big export-import sectors, and for our trade partners who are net exporters to the US and have tariffs applied to their goods, this is an unalloyed negative. And as I said, more-fractious trade relationships reduce the Ricardian comparative advantage gain for the system as a whole. It’s just really important to remember that the gains accrue to the system as a whole. The question of whether a country imposing tariffs has a gain or a loss on net comes down to whether the growth of the relative slice outweighs the shrinkage of the overall pie. In the US case, it most certainly does.
  4. Trade wars are bad for inflation, everywhere. I’ve written about this at length since Trump was elected (see here for one example), and I’d speculated on the effect of slowing trade liberalization even before that. In short, the explosion of free trade agreements in the early 1990s is what allowed us to have strong growth and low inflation, even with a fairly profligate monetary policy, as a one-off that lasted for as long as trade continued to open up. That train was already slowing – partly because of the populism that helped elect Mr. Trump, and partly because the 100th free trade agreement is harder than the 10th free trade agreement – and it has gone into reverse. Going forward, the advent of the trade war era means we will have a worse tradeoff of growth and inflation for any given monetary policy. This was true anyway as the free-trade-agreement spigot slowed, but it is much more true with a hot trade war.
  5. Trade wars are bad for equity markets, including in the US. A smaller pie means smaller profits, and a worse growth/inflation tradeoff means lower growth assumptions need to be baked into equity prices going forward. Trade wars are of course especially bad for multinationals, whose exported products are the ones subject to retaliation.

In the long run, trade wars mean worse growth/inflation tradeoffs for everyone – but that doesn’t mean that every country is a net loser from tariffs. In the short run, the effect on the US of the imposition of tariffs on goods imported to the US is clearly positive. Moreover, because the pain of the trade war is asymmetric – a country that relies on exports, such as China, is hurt much more when the US imposes tariffs than the US is hurt when China does – it is not at all crazy to think that trade wars in fact are winnable in the sense of one country enlarging its slice at the expense of another country or countries’ slices. To the extent that the trade war is “won,” and the tariffs are not permanent, then they are even beneficial (to the US) in the long run! If the trade war becomes a permanent feature, it is less clear since slower global growth probably constrains the growth of the US economy too. Permanent trade frictions would also produce a higher inflation equilibrium globally.

In this context, you can see that the challenge for monetary policy is quite large. If the US economy were not weakening anyway, for reasons exogenous to trade, then the response to a trade war should be to tighten policy since tariffs lead to higher prices and stronger domestic growth. However, the US economy is weakening, and so looser policy may be called for. My worry is that the when the Federal Reserve refers to the uncertainty around trade as a reason for easing, they either misapprehend the problem or they are acting as a global central bank trying to soften the global impact of a trade war. I think a decent case can be made for looser monetary policy – but it doesn’t involve trade. (As an aside: if central bankers really think that “anchored inflation expectations” are the reason we haven’t had higher inflation, then why are they being so alarmist about the inflationary effects of tariffs? Shouldn’t they be downplaying that effect, since as long as expectations remain anchored there’s no real threat? I wonder if even they believe the malarkey about anchoring inflation expectations.)

Do I like tariffs? Well, I don’t hate them. I don’t think the real economy is the clean, frictionless world of the economic theorists; since it is not, we need to consider how real people, real industries, real companies, and real regimes behave – and play the game with an understanding that it may be partially and occasionally adversarial, rather than treating it like one big cooperative game. There are valid reasons for tariffs (I actually first enumerated one of these in 1992). I won’t make any claims about the particular skill of the Trump Administration at playing this game, but I will say that I hope they’re good at it. Because if they are, it is an unalloyed positive for my home country…whatever the pundits on TV think about the big bad tariffs.

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.

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.

The Important Trade Effects Are Longer-Term

The question about the impact of trade wars is really two questions, and I suppose they get conflated a lot these days. First, there’s the near-term market impact; second is the longer-term price/growth impact.

The near-term market impact is interesting. When the market is in a bad mood (forgive the anthropomorphization), then trade frictions are simply an excuse to sell – both stocks and bonds, but mostly stocks. When the market is feeling cheerful, and especially around earnings season, trade wars get interpreted as having very narrow effects on certain companies and consequently there is no large market impact. That is what seems to have happened over the last few weeks – although trade conflicts are escalating and having very concentrated effects in some cases (including on markets, such as in commodities, where they really oughtn’t), it hasn’t dampened the mood of the overall market.

In fact, the risk in these circumstances is that a “happy” market will take any sign of a reduction in these tensions as broadly bullish. So you get concentrated selloffs in single names that don’t affect the market as a whole, and when there’s any sign of thawing you see a sharp market rally. We saw a bit of that in the last day or so as Mexico’s President-elect and US President Trump both expressed optimism about a ‘quick’ NAFTA deal. Honestly, the broad market risk to trade in the near-term is probably upwards, since any increase in tensions will have a minor and concentrated effect while any thawing (especially with China) at all will cause a rally.

But beware in case the mood changes!

As an inflation guy, I’m far more interested in the longer-term impact. And there, the impact is unambiguous and bad. I’ve written about this in the past, in detail (see this article, which is probably my best on the subject and first appeared in our private quarterly), but the salient point is that you don’t need a trade war to get worse inflation outcomes than we have seen in the last 20 years. You only need for progress on advancing global trade to stop. And it seems as though it has.

Not all of the forces pressing on inflation right now are bullish, although most are. Apartment rents have slowed their ascent, and the delayed effect of the dollar’s rally will have a dampening effect next year (arrayed against that, however, are the specific effects of tariffs on particular goods) although globally, FX movements are roughly zero-sum in terms of global inflation. Money growth has slowed, to levels that would tend to contain inflation if velocity were also to remain stable at all-time lows. But velocity recently started to uptick (we will find out on Friday if this uptick continued in Q2) and as interest rates gradually increase around the globe money velocity should also quicken. The chart below (source: Enduring Investments) shows our proprietary model for money velocity.

At this point, trade is pushing inflation higher in two ways. The first is that arresting the multi-decade trend towards more-open markets and more-numerous trade agreements fundamentally changes the inflation/growth tradeoff that central banks globally will face. Rather than having a following wind that made monetary policy relatively simple (although policymakers still found a way to louse it up, potentially beyond repair, largely as a result of believing their own fables about the powerful role that central banks played in saving the world first from inflation, and then from deflation), there will be a headwind that will make monetary much more difficult – more like the 1960s and 1970s than the 1980s, 1990s, and 2000s. The second way that trade conflict is pushing inflation higher is mechanical, by causing higher prices of recorded goods as a direct result of tariff implementation.

But this second way, while it gets all the ink and causes near-term knee-jerk effects in markets, is much less important in the long run.

Tariffs Do Not Cause Price Declines

July 5, 2018 7 comments

Adding to a good’s price does not make its price decline.

It’s worth repeating that a couple of times, because it seems to be getting lost in the discussion about tariffs – in particular, in the discussion about tariffs levied on US commodities. Grains prices have been plummeting, as the chart below showing front corn and soybean prices (source: Bloomberg) illustrates.

There are many reasons that grains prices may be declining, but if “tariffs have been levied on US production” is one of them then there is some really weird economics happening. Corn and soybeans are commodities. Specifically, this means that they are essentially fungible – corn from site “A” is essentially the same as corn from site “B.” So what does this mean for the results of a tariff?

If China stops buying soybeans from the US altogether, it means that unless they’re going to stop eating soybeans they will buy soybeans from Brazil. But if Brazil sells all of their soybeans to China, it means that Germany can no longer soybeans from Brazil. So where does Germany buy its soybeans from? Well, it seems that the US has beans that are not spoken for in this scenario…in other words, when we are talking about commodities a tariff mostly just reorganizes the list of who is buying from whom. If soybean prices are falling because China isn’t buying our soybeans, it means a great deal for Russia or Germany or whoever else is going to buy beans from us instead of from China’s new supplier. More than that, if global soybeans prices are falling because of tariffs then it means that everyone is getting cheaper soybeans because China is changing who they’re buying from. If that’s the case, then we really need to slap tariffs on everything and watch prices decline!

Let’s go back to elementary microeconomics. Adding a tariff is reflected in our product market supply and demand curves as a shift in the supply curve to the left: the quantity that producers are willing to supply at any price declines, because the price to the producer declines. Put a different way, the market price required to induce any particular quantity supplied rises by the amount of the tariff. Now, whether that causes market prices to rise a lot or a little, or quantity supplied to fall by a lot or a little, depends on the elasticities of supply and demand. If demand if fairly inelastic (which seems reasonable – you may be able to substitute for “beans” but it’s hard to substitute for “grains”), then you will see more of a price response than a quantity response, at least in the short run where the supply of beans is fairly inelastic. But that price response is up, not down.

By the way, this gets a little hard to illustrate with supply and demand curves, because with a tariff what you have are now two separate markets and separate prices for the same good. This is what confuses some people – if China is no longer buying from the US, doesn’t that mean that demand for US beans has declined, and therefore prices should decline? The crucial point is that we are talking here about commodity goods, and supplies are fairly interchangeable. If we are talking about Harley Davidson motorcycles, the answer is different because if Europe stops buying Harleys, they have to buy a different product altogether. In that case, the global price of “motorcycles” might be relatively unaffected, but the price of Harleys will rise (and the output decline) relative to other motorcycles. So, a tariff on Harley-Davidson motorcycles definitely hurts the US, but a tariff on soybeans – or even “US soybeans” since that is not a universal distinction – should have virtually no effect on US producers. And certainly, no effect on the global price of soybeans.

There are other reasons that grains prices may be declining. Since Brazil is a major producer of beans, the sharp decline in the Brazilian Real has pushed the US dollar price of beans lower (see chart, source Bloomberg). In the chart below, the currency is shown in Reals per dollar, and inverted. This is a much more important factor explaining the decline in grains prices, as well as one that could easily get worse before it gets better.

I think the discussion of the effects of tariffs has gotten a bit polluted since the decline in grains seems to coincide with the announcement of tariffs from China. I think the price decline here has fed that story, but it’s bad economics. Piecemeal tariffs on commodity products are not likely to appreciably change the supply and demand outcome, although it will result in rearranging the sources of product for different countries. Tariffs on non-commodity product, especially branded products with few close substitutes, can have much larger effects – although we ought to remember that from the consumer’s perspective (and in the measurement of consumer inflation), tariffs never lower prices faced by consumers although they can lower prices received by producers. This is why tariffs are bad – they cause higher prices and lower output, and the best case is no real change.


DISCLOSURE: Quantitative/systematic funds managed by Enduring Investments have both long and short positions in grains, and in particular long positions in Beans and Corn, this month.

Being Closer to the ‘Oh Darn’ Inflation Strike

April 19, 2018 5 comments

The time period between spikes of inflation angst seems to be shortening. I am not sure yet about the amplitude of those spikes of angst, but the concern seems to be quickening.

This is not without reason as it seems that concerning headlines are occurring with more frequency. This week the Bloomberg Commodity Index again challenged the 2016 and 2017 highs before backing off today (see chart, source Bloomberg).

Somewhat more alarming than that, to people who watch commodities, is how the commodity indices are rallying. The culprits are energy as well as industrial metals, and each has an interesting story to tell. Energy has been rallying partly because of global tensions, but also partly because US shale oil production appears to be running into some bottlenecks on production (wages, shortages of frack sand) as well as delivery (capacity constraints on pipelines), and part of what has kept a lid on energy prices over the last couple of years was the understanding that shale oil production was improving rapidly and becoming lots more efficient due to improved technology. If shale is limited, the ‘lid’ on prices is not as binding as we had thought. On industrial metals, some of the upward pressure has been due to fallout from US sanctions on Rusal, a major supplier of aluminum and alumina. Since those sanctions were announced, aluminum prices have risen around 25%, and alumina (a raw input to aluminum production) about 50%, with knock-on effects in other industrial metals.

Both of these items bear on the market’s recent fears about new pressures on inflation – capacity constraints (especially rising wages for long-haul truckers) and potential fracturing of the global trade détente.

And 10-year breakevens are at new 4-year highs, although it is worth remembering that this is nowhere near the 10-year highs (see chart, source Bloomberg).

Shorter inflation swaps look less alarming, and not at new four-year highs. However, even here the news is not really soothing. The reason that shorter inflation swaps are lower than they have been in the past is because the energy curves are in backwardation – meaning that the market is pricing in lower energy process in the future. In turn, this means that implied core inflation – once we strip out these energy effects – are, in fact, at 4-year highs (see chart, source Enduring Investments).

So there is legitimate cause to be concerned about upside risks to inflation, and that’s one reason the market is a bit jumpier in this regard. But there is also additional premium, volatility, and angst associated with the level of inflation itself. While as I have pointed out before much of the rise in core inflation to date due to optics arising from base effects, that doesn’t change the fact that the ‘oh, rats’ strike is closer now. That is to say that when core inflation is running at 1.5%, stuff can go wrong without hurting you if your pain threshold is at 3%. But when core inflation is at 2.5% (as it will be this summer), not as much “bad stuff” needs to happen to cause financial pain. In other words, both the ‘delta’ and the ‘gamma’ of the exposure is higher now – just as if one were short a call option struck at (say) 3% inflation. Because, implicitly, many investors are.

If inflation is low, then even if it is volatile in a range it can be consistent with high market valuations for stocks and bonds. But when inflation starts to creep above 3%, those markets tend to suffer in non-linear fashion.

And this, I believe, is why the market’s nervousness about inflation (and market volatility resulting from that nervousness) is unlikely to soon abate.

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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