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Biden Changes the Rules of the Simulation

It’s like a classic Star Trek scene where we learn the true genius of Captain Kirk – what sets him apart from other great leaders.

SAAVIK: Sir, may I ask you a question?
KIRK: What’s on your mind, Lieutenant?
SAAVIK: The Kobayashi Maru, sir.
KIRK: Are you asking me if we are playing out that scenario now?
SAAVIK: On the test, sir, will you tell me what you did? I would really like to know.
McCOY: Lieutenant, you are looking at the only Starfleet cadet who ever beat the no-win scenario.
SAAVIK: How?
KIRK: I reprogrammed the simulation so it was possible to rescue the ship.
SAAVIK: What?
DAVID: He cheated!
KIRK: I changed the conditions of the test. I got a commendation for original thinking. …I don’t like to lose.

Star Trek II: The Wrath of Khan (See the scene here)

Kirk beat the no-win scenario by reprogramming the simulation. Now consider the parallels with the current situation, as Captain Biden paces the bridge.

The economy is booming: Q2 GDP is forecast to have advanced at an 8.5% annualized pace (the GDP report will come out Thursday). However, at the same time Initial Unemployment Claims have remained stubbornly high and many remain out of work. In the meantime, inflation has become the number one concern of consumers and they’ve stopped listening credulously to claims that the widespread price increases are “transitory” as company after company reports price pressures and shortages that go far beyond used cars! A single article in Fox Business listed Kimberly Clark (toilet paper products), Harley Davidson (motorcycles), Whirlpool (large appliances), General Mills (food), and Constellation Brands (beer and booze) as companies that have recently announced price increases under pressure from cost increases. And there are hundreds of others.

The Captain is also aware that the reaction to the new directly-deposited monthly stimulus checks, which is obviously meant to be a down payment on (and habituate taxpayers to) “universal basic income,” did not produce the expected accolades from the crew. To be blunt, it went over like a damp squib and morale is not good.

If the Administration increases spending even more, then the bottlenecks and shortages that have helped produce quarter-over-quarter inflation at a roughly 10% pace in Q2 are not going to get better. And if the Administration tries to reduce spending to take pressure off of product markets and some of the froth out of securities and asset markets, then growth could suffer (and employment, especially his own, could be at risk!). It’s a no-win scenario…unless…

So Biden broke out of the frame. He re-wrote the rules. He is going to spend an additional $4 trillion on infrastructure. But he is beating the Kobayashi Maru scenario, because this massive spending program is going to create jobs and heal the economy and also reduce inflation.

“If your primary concern right now is inflation, you should be even more enthusiastic about this plan,” Biden said in remarks from the White House State Dining Room. “These steps will enhance our productivity, raising wages without raising prices, and won’t increase inflation. It will take the pressure off of inflation.” – Captain Joe Biden

Genius.

Of course, it’s only possible if Biden succeeds in re-programming reality. Because in the world we actually live in, that’s not the way this works. Massive government spending programs, financed by feckless central bank financing of deficits, always leads to inflation.

The President’s claim – although, let’s be fair, he’s just reading cue cards so it’s someone else making the claim and forcing the poor guy to say the crazy things – is that by making “prudent, multi-year investments in better roads, bridges, transit systems and high-speed internet and a modern resilient electric grid, here’s what will happen: It breaks up the bottlenecks in our economy; goods get to consumers more rapidly and less expensively; small businesses create and innovate much more seamlessly.”

Let’s ignore for the nonce the government’s record of making “prudent investments.” And let’s be generous and imagine that the trillions and trillions of dollars of spending will actually result in the things he claims it will. It still doesn’t solve the problem, which is that right now there are massive supply issues, mostly because every consumer has more money now than they did before the shutdown and they’re spending it. There’s too much money chasing too few goods, today! As far as I can ascertain, prices are not shooting higher because the nation’s bridges aren’t good enough, and the internet isn’t fast enough. But even if they were, pushing more cash into the economic system to solve that problem years in the future makes today’s problem worse. The fact that this spending is not being done by the private sector but by the public sector compounds the mistake.

The only way to get the results he wants is to re-write the simulation so that it doesn’t work this way. So I assume that’s what he has done. (I would say, as David does in the script above, “he cheated”, but that evokes other things we aren’t supposed to talk about these days.)

Well done, Captain Joe!

Summary of My Post-CPI Tweets (July 2021)

July 13, 2021 5 comments

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

  • Another very special #CPI day! Welcome to my data walk-up.
  • Before we get started, let me tell you that I’ll be on @TDANetwork with @OJRenick this morning around 9:15ET. Accordingly, my post-CPI stuff might be slightly abbreviated. I’ll try to go quickly.
  • Setting the stage: we’re coming off of three consecutive upside surprises to core CPI. In each case, the interbank market trade was closer than the economists. Three months of 0.34%, 0.92%, and 0.74% m/m were impressive. Core CPI is at its highest since June 1992.
  • We were set to see the y/y figures rise on base effects anyway, but these were strong on a month/month basis – which have nothing to do with base effects.
  • It’s true the m/m figures were clearly flattered by the “COVID categories” like airfares (+7% last month) and used cars (+7.3% last month). But while the “transitory” crowd wants you to think that is the whole story, it’s not.
  • The truth is that the root cause here is phony demand caused by government spending financed by a loopy guy with a printing press. It is not “due to the reopening.”
  • I thought I made the point pretty well in “We Were Shocked – Shocked! – that Massive Stimulus Caused Inflation” https://mikeashton.wordpress.com/2021/06/23/we-were-shocked-shocked-that-massive-stimulus-caused-inflation/
  • In addition to the big outliers, there are a cluster of categories with y/y changes between 3% and 5%. Not all COVID categories! Our diffusion index is the highest since 2012.
  • So what is up for today. The ‘comp’ from last year is a more normal one, at +0.24%. The consensus economist forecast is +0.4% on core CPI, with the interbank market trading just a smidge higher than that. This sort of print would put y/y core CPI at (gulp) 4.0%.
  • Used cars still have some juice in them, based on Black Book and other numbers, so they’ll probably still be up in the ballpark of 3-4% m/m (huge error bars there). Still big, but getting to the end of the craziest m/m figures.
  • I want to keep an eye on new cars. That category is less volatile than used cars, but larger (~3.75% of CPI) and it looked last month like it was starting to accelerate.
  • There have been reports that some used car prices are above the prices of the same car, new. There are two ways that can change to something more normal. Used car prices can ebb, or new car prices can rise (or both, obviously). So keeping an eye on new cars.
  • Car rental rates have also been skyrocketing due to the shrunken fleets, and the surge in vacationers with stimmy money. Rental companies need more new cars.
  • But beyond the “COVID categories,” the key looking forward is (a) the breadth of the inflation increases, about which I’ve already commented, and (b) rents.
  • The eviction moratorium is still in place until the end of July, so the big catch-up that will happen when non-payers are turned out in favor of payers will not happen for at least a month or two.
  • But there is some evidence that the units that ARE turning over are at a high rent…so I suspect we will see more lift from rents this month, though the big months are ahead.
  • The timing of the end of the moratorium and the catch-up in rents is interesting, because the “hard” comps from 2020 are coming up. July ’20 was +0.54 core and August was +0.35%. So y/y might decline a bit over next few months (though this isn’t guaranteed with recent trends!)
  • Back at the beginning of the year, that was our expectation – a ‘fog of war’ from base effects causing a big jump then a big decline. However, the jump was bigger than expected and the decline may not be as impressive as we’d thought.
  • Rent catch-up might be worth 0.9% or so on core, so depending on how long the catch-up takes, the turn in the base effects might not be as impressive as we thought just a few months ago.
  • The Fed “cares” about such a move, especially if it’s broader… until stocks drop 5%. And then I suspect they’ll care more about keeping the wheels on the bus. So I’m not sure we’re about to see a sharp drop in QE very soon.
  • OK that’s all for the walk-up. Number is in 5 minutes. I think we might get a 4th upside surprise, but this is almost anticlimactic. The rest of 2021 is all about the rents.
    • duh, 2022.
  • And after August, the next 6 months of core CPI average just 0.1%. So folks, I don’t think we’ve seen the highs yet. If we average 0.3% per month on core, we could see 5% core CPI y/y by early 2021!

  • That’s a transitory bus that just hit us.
  • 0.88% m/m on core, pushing the y/y to 4.453%. So if it makes you feel better, both were rounded higher.
  • Well, CPI for Used Cars was +10.5% m/m, which is a lot more than I was looking for. That’s part of this.
  • COVID- categories: airfares +2.7% m/m. Lodging Away from Home (was flattish last month) +6.95% m/m. New Cars and Trucks +1.97%. Car and Truck Rental +5.18%.
  • Core Goods, thus, is at 8.7% y/y.
  • Of course, ex-everything-except- Medical Care, we are in deflation. Medical Care CPI was -0.10% this month.
  • Food Away from Home is up at a 4.23% y/y pace. But I am watching Food-at-Home, given the unrest we are starting to see around the world that smacks of the Arab Spring. Food-at-home was only +0.9% y/y.
  • Meat, poultry, fish, and eggs were +2.6% m/m, but most of the food-at-home category was reasonably well-behaved.
  • I haven’t mentioned rents yet because they were reasonably ham-on-rye. OER was +0.32% m/m, pushing the y/y to 2.34%; that’s a pretty normal monthly figure. Primary Rents, more directly affected by a spike in asking rents, was +0.23% m/m. So nothing there yet.
  • Core CPI ex-housing was 5.81% y/y, the highest since 1984. Of course it’s those COVID categories so this doesn’t tell us anything we didn’t already know. We’re going to want to look at the breadth.
  • Health Insurance was -1% m/m, and is now -6.9% y/y. Remember this was over 20% a while back and I THOUGHT that meant we’d eventually see pass-through to the other medical categories since Insurance is a residual. I’ve been wrong on that. No idea what is happening in med care.
  • So, we have a huge core number. What about median? In an inflationary cycle we’d expect core to be above median but a rise in median should still happen. Not worrisome yet…I am estimating +0.24% m/m for median this month.
  • at about 9:15ET, so as I said earlier this is a bit abbreviated. Apologies for that.
  • I have to go get ready to be on @TDANetwork
  • But here’s a quick summary: there’s nothing NOT scary about 0.9% on core. Except that there didn’t seem to be a lot of signs of further broadening of price pressures, and the pressure on rents hasn’t shown up yet. Indeed, Used Cars might have overextended & be due for a retrace.
  • We know what will lead the headlines! And four misses to the upside in a row runs the risk of un-anchoring expectations… but the next few months, post-eviction-moratorium, will be very important. Next two months will be tougher comps. But…0.9% would still beat them!

It was a quick one today. It is funny to think that just a few months ago, any 0.9% print on core CPI would have been interesting! Over the last quarter, prices have risen at a 10% annualized pace. Over Q2, core prices rose more (2.55%) than in the prior 18 months combined.

And yet, the 0.9% print was not too unusual. As noted, used car prices were up a lot more than I expected; basically, the entire spike in private surveys has now passed through to the CPI. Unless used car prices continue to rise at a similarly-blistering pace, that category probably shouldn’t add a lot to core CPI going forward.

New cars, on the other hand, are accelerating – the price of a substitute good normally does move in concert with the reference good – as the chart below shows. This is a potential source of surprises going forward. Or if not “surprises,” at least continuing momentum from the car crunch.

Other “COVID categories” were also bubbly. But that wasn’t surprising in itself. What I was on the lookout for was, as I said earlier, (a) a further broadening of price pressures, and/or (b) an early acceleration in rents even before the eviction moratorium expires, as various measures of asking rent suggest should be starting to happen. The chart below, of the Enduring Investments Inflation Diffusion Index, shows that the index was roughly unchanged this month near recent highs…so, no evidence yet of further broadening of inflation.

And, as noted above, Primary Rents and Owners’ Equivalent Rent were similar to the pre-COVID trend, but not yet reflecting the dynamics in the housing market. They almost always do, albeit with a lag. Our model below shows the effect of the moratorium as the difference between the current OER level and the model level, but note that the model also continues to rise for quite a while here. This is why it’s fairly easy to forecast that core inflation is going to stay elevated for a lot longer than the market is pricing. If the model is right, and rents rise at 4.75%, then if all core-ex-shelter components rise at only 2% the overall core index would still be at 3.1%. So when I predicted on TD Ameritrade Network this morning that core inflation for 2022 would average above 3% – a level it had not printed for even a single month in the last quarter-century until the last few months – I have some fair confidence in that. (Of course, the model could be completely wrong, or core-ex-shelter could be in outright deflation. But it’s also possible that core-ex-shelter could be rising at 3%).

This seems a good time to point out that 5-year breakevens are at 2.61% and 10-year breakevens are at 2.37%. There’s a lot of mean-reversion priced into those levels, and no long-tail-upsides.

This month, in short, we had COVID categories, broad inflation but no additional broadening, and no movement yet in rents. As far as 0.9s go, it was not too worrisome. On the other hand, if prices rise at a pace of 10% for very long then the Fed’s precious “anchored inflation expectations” are at serious risk. Ergo, I expect the Fed to start sounding more hawkish now. I also expect that they will drop the hawkish talk once stocks drop 5%. If stocks drop 10%, they’ll start actively talking about additional stimulus. This Fed is not of the talk-softly-but-carry-a-big-stick school. They’re of the talk-loudly-but-run-if-they-call-your-bluff type.

We Were Shocked – Shocked! – that Massive Stimulus Caused Inflation

June 23, 2021 2 comments

At one time, when I worked for big global banks, I wrote a commentary daily. As a consequence, I would remark on almost literally every “important” fed speech (the quotation marks being because, in the last decade or two, almost none of those speeches were at all meaningful since they had already given us the playbook in plain English). Nowadays, I delight in the fact that I don’t regularly have to comment on the drivel that dribbles from fed mouthpieces. At times, though, it becomes too much to ignore and something need to be said.

“A pretty substantial part, or perhaps all of the overshoot in inflation comes from categories that are directly affected by the re-opening of the economy such as used cars and trucks.”

Jerome Powell, June 22, 2021

This has become a very easy meme for Fed officials and disinflationistas: inflation is “transitory” over some unstated period, because almost everything we are seeing is the direct result of the abrupt reopening of the global economy.

Let’s examine that. In what way is the price increase in used cars and trucks due to the reopening?

In a normal cycle, there wouldn’t be sudden and huge demand for used cars all of a sudden. Nor would there be a sudden and huge demand for all sorts of other goods and services – shipping containers, chlorine, semiconductor chips, polypropylene, contract labor. In a normal cycle, demand recovers gradually and supply adjusts to the new demand gradually. Suppliers have time to read market signals and to bring new production on-line. A manufacturer of plastic doodads forecasts that in three months, he’s going to have enough demand to need a second shift – so, he puts advertisements in the paper and starts to selectively hire workers for a second shift. When the demand shows up, he is ready.

So clearly, the big mismatch between supply and demand in this cycle is the problem. And it isn’t just in used cars and trucks. It isn’t just in hotels and airfares. In fact, it is a myth that there is a small set of categories that are inflating wildly while other prices are inert. The chart below shows Enduring Investments’ Inflation Diffusion Index. More categories are seeing acceleration inflation, than are not.

Sure, a few categories add most of the acceleration, mathematically. That is always true. The combination of weight in the basket and size of the move means you can always point to one item or set of items that this month caused a big increase. I first mentioned my “microwave popping corn” analogy back in October. The fact that you can identify a particular reason that a kernel popped does not mean that you have found the root cause of all of the kernels popping. (As an aide, that article addressed the rise in used car prices that was just starting to happen. Back in October, when most of the world was still 90% on lockdown).

Again, there’s no question about the fact that one link in the causal chain is that demand came back before supply could prepare for it. But whose fault is that?

It isn’t merely the fact of the reopening. If Administration officials had simply decided on January 1st to let people go back out into the world again, demand would not have exploded overnight. Buying things requires money. In a normal cycle, suppliers would have started to hire for the reopening; they would have paid the workers, who would then have money; some of those people would go and buy used cars. It would surely have happened more quickly this time since the gate was being removed all at once. But many consumers would have had to spend time repairing their personal balance sheets and would not have suddenly gone out to buy new cars. Instead, what happened is that the Congress dropped a couple trillion dollars into consumers’ accounts, and – a crucial part of this sequence – the Fed bought the bonds that the Treasury had to issue in order to spray that money into the economy.

That last step is important. If the Treasury had just spent a trillion dollars and issued a trillion dollars’ worth of bonds, it would have had an impact but only because the money was being sent to consumers with a high propensity to consume, while the money being pulled in to pay for it was coming from investors with a lower propensity to consume (investors buying the bonds now have less cash to spend). So the spending package would matter, but not nearly as much as spending a trillion, and issuing bonds which the Federal Reserve expands the money supply to buy. A great chart from Deutsche Bank Research illustrates this cleanly: the Fed bought a huge proportion of the bonds the Treasury sold.

So trillions of dollars of the demand pressure are coming from debt being sold to a guy with a printing press. That is fake demand. It is not “due to the reopening.” It’s due to spastic fiscal policy, coupled with profligate monetary policy. And, as the used car example shows, it started happening long before the economy was getting “back to normal.” So while Powell and his minions feign surprise and shock at the outcome, it only means they are either deceitful or incompetent. The root cause here is absolutely clear, and the only reason that Chairman Powell can get away with claiming otherwise is that he is speaking to another body that is even more deceitful and incompetent.

Categories: Uncategorized Tags: ,

Summary of My Post-CPI Tweets (June 2021)

June 10, 2021 1 comment

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

  • It’s #CPI day again! Welcome to my data walk-up. And a special welcome to all the new followers this month. I can probably plot new followers as an indicator of interest in the subject of inflation.
  • As the inflation guy, I ALWAYS look forward to this day but this is one that is going to be a lot more-widely watched than most. And for good reason.
  • Last month, core CPI shocked everyone with a +0.92% m/m reading, the highest in 40 years; the y/y core was the highest in a quarter-century. And this month, the y/y core will rise to the highest level since the early 1990s. Only question is what year in the early 1990s.
  • That’s baked in the cake; the comp from last May was -0.07% so core will rise today, by a lot. Consensus is +0.5% m/m, pushing y/y to ~3.5%. The inflation swaps market is slightly above that, more like 0.6%. And the swaps market has been right on the last couple of surprises.
  • Before we relitigate last month’s print, let’s actually look to the PRIOR month, the March figure that dropped [ed. note: meaning, “was released”, not “declined”] in April. With last month’s fireworks we forget that March’s number (+0.34% m/m on core) was also a surprise. Moreover, it was a BROADER surprise.
  • The March CPI was NOT flattered by airfares and used cars, which were the main culprits from last month. Nor by rents. It was due to large moves in small components that no one was expecting to see jump.
  • Honestly we could see last month’s jump coming (maybe not that much). March was a true surprise.
  • THAT is the story we need to be watching behind the fireworks. The Enduring Inflation Diffusion Index, meant to measure the breadth of inflation pressures, last month reached the highest level since 2012.
  • The Fed can write off Used Cars as “transitory.” But it’s less plausible that EVERYTHING is transitory.
  • (At some level, “Transitory” doesn’t really mean anything useful unless you specify the period – see my note “All Inflation is Transitory” https://mikeashton.wordpress.com/2021/05/20/all-inflation-is-transitory/ )
  • So now moving forward to April’s figure last month. Used cars and airfares were both up more than 10% m/m. Lodging Away from Home rose 7.65% m/m. And that was the reason for the massive move.
  • Spoiler alert: last month’s rise in Used Cars CPI is only a fraction of what is still coming. See chart of the Black Book index vs the CPI for Used Cars.
  • Does that mean we will get another 10% rise in Used Cars this month? It actually could be worse (although the rise in the data could also smear over several months). This is why it’s not heroic to forecast 0.5% m/m on core CPI. Can get there easily.
  • Airfares and Lodging Away from Home should also see upward pressure but there are more zigzags there. But what I really want to look at are Primary Rents (you are a renter) and Owners’ Equivalent Rent (you own your home).
  • The eviction moratorium, which by my estimate is dampening overall core CPI by around 0.9% through the medium of rents and OER, is still in place. So we DON’T have an a priori reason to look for a rental jump. Thus if we get one – it will be caused by something else.
  • That something else is that as the country has opened up, and people have been moving hither and yon, rents have been jumping (along with home prices) even more than before. And some of that might find its way into the CPI. It probably should.
  • Without housing turning higher, it’s hard to sustain big inflation figures. But rents are going to turn higher, just not clear exactly when.
  • And of course, I’ll be looking at the broader pressures down the stack to the little stuff. That’s where the high cost of containers, plastics and packaging, freight, and the shortage of labor (among many other things) is going to show up.
  • MY GUESS is that rents stay tame with just a little uptick, used cars are still strong, we see a little strength from new cars as well, and we get another above-consensus number. I can come up with scary scenarios for this print. It’s harder to come up with gentle ones.
  • Well it should be a barn-burner. Up until now, the Fed hasn’t cared. Last month got them to talk about talking about someday maybe not doing as much QE. Another month might accelerate that talking about talking. Especially if it’s more than Used Cars.
  • But the comps get “harder” for the next 3 months; Jun-Aug 2020 were +0.24%, +0.54%, and +0.35% on core CPI. So we’ll need the strength to last into the fall before the Fed gets truly nervous. And I still think the clear majority doesn’t put inflation as a serious priority.
  • It’s up to the bond vigilantes to push the Fed to being more serious about inflation. But the bond vigilantes are enjoying the “Greenspan put” equivalent in the bond world.
  • Buckle up! That’s my walk-up. Number is out in a few.

  • Surprise! It’s a surprise. 0.7% on core.
  • Actually 0.74% m/m on core, for those who still care about hundredths! Y/y is 3.80%.
  • Core highest since June 1992.
  • Lagarde comments that inflation pressures in Europe remain subdued. READ THE ROOM!
  • Used cars +7.29% m/m. OER +0.31%. Primary Rents +0.24%. Airfares +6.98%. All of those are m/m.
  • Used Cars…still could have more to go!
  • Another month of changing the scale on my charts. Here is core goods and core services. Core goods (used cars) is getting the play but don’t ignore the recovery in core services.
  • That rise in core services is with Medical Care very very soft. Pharma (which is core goods) was -0.08% m/m; Doctors’ Services -0.03%; Hospital Services +0.16%. This remains a real conundrum.
  • Apparel was +1.22% m/m. Now, apparel is only 3% of the overall CPI, but I think we’re seeing the effect of shipping costs here since most apparel is imported.
  • The small rise in rents was in line with my expectation. But we haven’t yet seen any of the real jump to come when the eviction moratorium is ended.
  • Core CPI ex-shelter was +4.94% y/y. That’s something we haven’t seen since 1991. Of course, that’s also mostly cars at this point. Need to get further down the stack to see how broad it is.
  • It probably though IS worth noting that the rise in core-ex-shelter isn’t compensating for a prior collapse. It dipped some in early COVID. But we’re way beyond that.
  • I’d also mentioned expecting to see some participation in new cars. Here is y/y. Partly this is rise in the price of a substitute, part is increased costs (from plastics and rubber to steel).
  • Rise in New Car prices is a little harder to explain away than used cars, which is spiking partly because of 2020 rental fleet shrinkage, which leaves the supply of used cars tight.
  • Car and Truck Rental: tiny category but visceral. +10% m/m. If you’re traveling this summer and haven’t rented your car yet…you may already be too late. It’s hard to find them.
  • Domestic Services +6.42% m/m NSA. Moving/storage/freight expense (from consumer’s perspective) +5.5% m/m NSA, +16.2% y/y.
  • Early look at Median CPI, which gives a better look at pressures without outliers…my estimate is +0.32% m/m. That would be the highest in two years if I’m right. Median is never going to be as volatile as core, but we don’t want to see it +0.3% m/m regularly.
  • Key point about median and core though: in a disinflationary environment core will generally be below median. In an inflationary environment, it will generally be above. So if we’re shifting environments so all the tails are higher, then the core/median switch will persist.
  • My first glance at 10y breakevens since the number finds them +4bps on the day. They’ve been under pressure recently, I suspect less because people thought this would be a soft number and more because they’re looking for higher-inflation-beta products like commodities.
  • As a brief aside, I think people underappreciate what breakevens could do if there is a movement in investor allocations. There’s nearly $2 Trillion of TIPS outstanding. But the FLOAT is nowhere near that. When they’re gone, they’re gone.
  • Let’s see: rents tame with a little uptick. Check. Cars still strong. Check. a little strength from new cars as well. Check. Another above-consensus number. Check!
  • Let’s see. Biggest losers and gainers. No category had an annualized decline more than 10%. But above 10%: Infants/Toddler’s Apparel, Motor Vehicle Parts & Equipment, Meats Poultry Fish & Eggs, Household Furnishings and Equipment, Footwear, Women’s & Girls’ Apparel, (more)
  • Fuel Oil & other Fuels, Jewelry & Watches, Public Transportation, Used Cars and Trucks, Car and Truck Rental, Leased Cars and trucks.
  • Haven’t run this chart in a few months. Shows the distribution of lower-level price changes, y/y. The big middle finger is mostly OER. But look at not just the far right tail but the group between 3% and 5%.
  • Just a couple more items here. The diffusion index and then four-pieces. The Enduring Investments Inflation Diffusion Index rose to its highest level since 2012 today. Another way to look at the broadening of price pressures.
  • We will do the four-pieces charts and then wrap up. The four-pieces charts is a simple way of looking at the drivers of inflation. Each of the pieces is very roughly 1/4 of the index (20%-35% actually). But it puts like-with-like.
  • …and they’re also in roughly volatility-order. First, Food & Energy. BTW a lot of this is food for a change. Food inflation is not pretty. But this is ‘non-core.’
  • Piece 2 is core goods. We’ve already seen this. New and Used Cars, Medicinal Drugs, e.g. Clearly this is a big driver at the moment.
  • Piece 3 is core services less rent of shelter. And there’s no comfort here. This includes medical services, which really aren’t doing anything. Household services. Car rental. Stuff like that.
  • And lastly the slowest moving piece, Rent of Shelter. This is rising, but right now it’s mostly because of lodging-away-from-home. To be fair that was a big part of the prior slide. Rents as we have already seen aren’t doing a lot. Yet.
  • If you want to be optimistic about inflationary pressures, you want to have rents stay tame. This is really hard when home prices and asking rents are shooting higher. If you want inflation to be transitory, you really need a home price collapse. I don’t see that…
  • Not to say home prices aren’t a bit frothy right now. But the conditions for them to collapse nationally, pulling rents and thus inflation down with them as in 2009-10, don’t seem to be there. But that’s the biggest/only risk I see to higher inflation through 2021-22.
  • That’s all for today. I’ll publish a compiled tweet list on my blog later this morning. You can get that blog at https://mikeashton.wordpress.com . But if you want more than talk, visit Enduring Investments at https://enduringinvestments.com and drop me a line.
  • Thanks for tuning in. Hope all of you new followers are generous with your RT and follow recommendations!

A second month of large increases in core inflation should be followed by a second month of Fed speakers downplaying the importance of the ‘transitory’ price increases. The rise in used cars and lodging away from home play into that narrative, but there are broader pressures here and they will show up more this month in other inflation measures such as median or ‘sticky’ CPI. But if bond yields don’t respond to the inflation threat, then neither will the Fed. Talk is cheap, and it is easy to say that inflation pressures will be “transitory” (and surely, they won’t continue at 0.8% per month on core), but when that talk is backed up by a placid government bond market it keeps the pressure off of the FOMC to do anything.

To be sure, I don’t really expect the Fed to be doing anything anyway. While the entire Committee isn’t exactly in line, Chairman Powell is the vote that matters. And he (along with the moral support from Treasury Secretary Yellen) continues to repeat that inflation is not a problem, and anyway it isn’t as important as making sure that everyone has a job, at any cost. (Students of history should note that the early days of the Weimar inflation saw a similar preoccupation with getting everyone employed, even if money had to be printed to do it!)

So, we continue to watch our money lose value, with the policymakers continuing to fiddle while Rome burns. There are places to hide, but they will get crowded pretty quickly once everyone realizes they need shelter. I don’t think this inflation is “transitory” in anything but a trivial sense that it will eventually pass. We don’t have to get to 8% inflation for it to be damaging to the psyche of the investor, consumer, and producer who has become acclimated to 2%. Sustained core inflation near 4% would be sufficient to break the back of the disinflation of the last forty years, in my view. We should get a test of that thesis, because we aren’t going to see appreciably lower core numbers until sometime in 2022.

How Expecting Inflation Un-anchors Manufacturers’ Pricing Strategy

June 1, 2021 2 comments

I still think that “anchored inflation expectations” is a term that is devilishly difficult to define and measure, and therefore shouldn’t be a part of monetary policy planning. By the time you know that inflation expectations have become un-anchored, it’s too late to anchor them again because (theoretically) behaviors change when the inflation regime is perceived to have moved from “low and stable” to “higher and more volatile.” Generally left undiscussed is how behaviors change in this transition; it always sounds like the notion is that sellers can’t change prices, unless buyers expect them to do so…or unless sellers expect that buyer expect them to do so.

But there are some deeper mechanics of pricing that, we can illustrate, can produce a state-shift in pricing policy when expectations are for prices to generally rise. To the extent this happens, it could support the idea that once the state-shift happens, it is not trivial to shift it back.

Let’s first examine a case where a manufacturer expects cost increases to be followed by cost decreases, and vice-versa. Consider two pricing strategies: in one, the manufacturer passes through 100% of the cost increases to its price, so that its profit remains stable. The chart below shows costs per unit varying in blue, the producer’s price to its customers in red, and the net profit in green at the bottom.

An alternative pricing strategy is to pass through only a portion of the cost changes. In the chart below, the manufacturer adjusts prices only 25% of the movement in costs, absorbing the rest into its margin.

The second strategy results in a more-volatile earnings stream, but averages over time to the same level of profits. More usefully, it means a much more stable price to the customer, which customers clearly prefer. In the real world, where costs change more chaotically than this idealized oscillation, such price-dampening behavior likely leads to steadier end-customer demand and, over time, this potentially means more unit sales and greater total profit.

But now let’s turn to a case where instead of oscillating with no net change, we have costs oscillating on an upward trend. Now, when the manufacturer passes through 25% of the change, it sees a steady erosion in profitability since those costs never fully return to the prior level.

On the other hand, the manufacturer who is fully passing all cost changes along to the end customer sees steady profits, as before.

Moreover, the “full pass through” manufacturer no longer has the disadvantage of a more-volatile price. Because eventually, the partial-pass-through manufacturer will have to institute a large price change to become profitable again. It is not clear that a steady pricing policy punctuated with large step jumps is better than one that transparently passes through costs, from the end customer’s perspective.

The moral of the story is that a manufacturer who dampens cost swing pass-through in its pricing policy needs to be very good at knowing when the inflation environment changes, or be confident that inflation is low and stable generally. The manufacturer who passes costs through fully is already adapted for an environment of volatile inflation.

And, as more manufacturers move to the latter model, then inflation does become more volatile as the dampening behavior in the value-add processes goes away. Moreover, notice that the urgency to shift pricing regimes only works in one direction. A partial-pass-through producer can start losing money and feel a great urgency to shift to being a full-pass-through producer because it is losing money; but once a manufacturer has moved to full pass-through, there is not much urgency to move back. Ergo, once these shifts start to happen, inflation volatility gets somewhat institutionalized. In theory, we could measure the degree to which inflation expectations have become un-anchored by measuring the proportion of manufacturers’ changing costs that get passed through. As that percentage rises, it implies that manufacturers are growing more cautious about assuming mean-reversion in costs, and that they are moving closer to a model that works in an un-anchored environment and which tends to perpetuate that environment. I don’t know of anyone who has tried to do this, yet, but if policymakers are going to rely on “anchored inflation expectations” as a key component of their inflation models, they ought to examine ways to measure it better than just asking people whether their inflation expectations are anchored!

Categories: Uncategorized

Eighth-Grade Math vs ShadowStats

I spend a large amount of my time, when talking about inflation, addressing the quality of the Consumer Price Index and other measures of inflation. This is understandable because internalizing the effects of inflation so that “2.2% increase in my market basket” seems intuitive is, to put it mildly, challenging. But what is a little surprising is how much time I spend answering questions about the website ShadowStats. For many years, I assumed the website was a hoax since the claims made on it are patently ridiculous, but finally realized that the site’s owner actually believes that inflation has run at something like 5-7% higher than the “official” measures since the early 1980s, if you “use the method before the government made all the changes designed to lower the measure.” The basic claim is false – lots of people have looked at the impact of those changes on the future path of the index, and none of them has concluded that the methodological alterations make any more than a fractional difference over time. And there are lots of ways to illustrate that the substance of the claim is nonsense (see for example some of my arguments here). But the disturbing thing is that you don’t need to be an inflation nerd or mathematician to be able to prove that the claims are false. You just need eighth-grade math.

I’m assuming that they teach exponents in 8th grade, but I know in some venues they get taught earlier than that. I think I’m being conservative here. We are just going to focus on one formula:

(1 + annual growth rate)number of years = how many times as large something is at the end, vs the start

For example, if my bank account has $1 in it, and grows at 10% per year for 5 years, it is worth (1+10%)5 = 1.61x as much, or $1.61. I only walk through this in case the reader hasn’t been through 8th grade, or is too many years removed from the 8th grade, or works for ShadowStats.

Now let’s use real numbers. Since April 1981, roughly when the Bureau of Labor Statistics (BLS) started changing these methods in a sinister way (but chosen because it means it was exactly 40 years ago, which is nice and clean), the BLS says that prices have risen an average of 2.78% per year. This means that the general level of prices, according to the BLS, has almost exactly tripled. What cost $1 in 1981 costs about $3 now. Meanwhile, if instead we use an annual inflation figure that is (only) 5% higher, so that inflation averaged 7.78% per year, then the general level of prices has risen 20x.

(1 + .0278)40=3.00

(1 + .0778)40=20.02

What does that mean practically? Let’s look at the 1981 prices of various goods and services, then at the approximate 2021 price that would be implied by a tripling in the price level (BLS-based estimate) or by a 20x multiplication (ShadowStats-based estimate). Obviously, neither the BLS nor ShadowStats claims that all prices move the same amount as the average, but we’re talking an order of magnitude here so let’s just see who is closer. See the first footnote[1] for sourcing of 1981 prices and the second footnote[2] for current prices.

You don’t need to have a PhD in Mathematics to see that the implications of ShadowStats’ claim about “real” inflation being 5% or more higher than the CPI makes the claim obviously ridiculous on its face. (Note that I assumed a 5% spread above CPI – if you use a 7% spread then you can double the numbers again over what ShadowStats implies at a 5% spread.) A dozen eggs in 1981 cost $0.90. If that grew at 2.78% per annum, it would be $2.70 today; ShadowStats thinks you’re probably paying around $19. They also think a gallon of milk should be $34, a loaf of bread $11, and the median home price a cool $1.3mm. Your average new car? $115k, but that’s not nearly as bad as $6,300 per month for rent. By the way, note that my “actual” prices do not have “hedonic adjustments” in them, which is one of ShadowStats’ complaints they “correct” for. Those are actual prices for what you’d actually buy today, not the 1981 version.

I included Tuition on here because I wanted to have a line-item for the biggest inflator I could think of that we could all agree on. Clearly, tuition has increased by more than the 2.78%/yr of the whole basket. But even if it was an average item, ShadowStats would have tuition at double the current rates (four times the current level, if you use a 7% spread, and more, if you apply that spread to what the BLS estimated).

So I think we can be definitive here: the BLS may not be right about the exact price level or the exact change of the mythical consumption basket. But CPI is not, cannot be, dramatically wrong the way that ShadowStats claims that it is. Eighth grade math proves it.


[1] Sources for 1981 prices: car, gallon of milk, bread from http://www.inthe80s.com/prices.shtml. Rent, dishwasher, gallon of gas, median home price from http://www.thepeoplehistory.com/1981.html. McDonald’s hamburger from https://www.insider.com/fast-food-burgers-cost-every-year-2018-9#in-2018-your-burger-costs-an-average-of-264-25. Private 4y college tuition from https://research.collegeboard.org/trends/college-pricing/resource-library. First-class stamp, dozen eggs from http://www.1980sflashback.com/1981/economy.asp.  

[2] Sources for 2021 prices: cars: https://www.kbb.com/car-news/new-car-and-suv-buyers-guides/. Rent: https://www.rentable.co/blog/annual-rent-report/. Dishwasher (installed): https://www.homeadvisor.com/cost/kitchens/install-dishwasher/. Burger (delivered!): I checked UberEats in NJ. Stamp: USPS. Gallon of gas: https://gasprices.aaa.com/state-gas-price-averages/. Eggs, milk, and bread: Wal-mart online. Median home price: https://fred.stlouisfed.org/series/MSPUS. Tuition (2020-21 school year): https://research.collegeboard.org/trends/college-pricing/resource-library.  

Categories: Uncategorized

ALL Inflation is Transitory

May 20, 2021 5 comments

The Federal Reserve has recently started to use the word “transitory” when describing inflation pressures in the U.S. economy. What they’re trying to indicate is that we shouldn’t worry, the pressures we are seeing right now will eventually pass. But that’s stupid. All inflation is transitory.

The word “transitory” is meaningless, unless you tell me what you’re transiting from, where you’re transiting to, and how long it will take. When I say that the lunar eclipse is transitory, I can define exactly what I mean: the entirety of the disk will be obscured for x amount of time at this particular terrestrial location. But in inflation, saying it is “transitory” is just a weasel word. The inflation of the 1970s was transitory. It was just a long transit.

From what level do you mean it’s transitory? Inflation has been above zero for seventy years, core inflation for another decade longer than that. Maybe that’s transitory, but we just haven’t finished the transit yet. Presumably, the Fed isn’t saying inflation will go back to zero…maybe they mean it will go back to 2% on core? Or perhaps they mean the average of the last few years, well below that? Unclear. So as usual, the Fed is getting the wrong answers because they’re asking the wrong questions.

Maybe what they mean is that “these price changes we are seeing are all the results of supply and demand imbalances in nominal space, so they’ll all reach equilibrium and inflation will go away.” If that’s so, then (a) they’re probably wrong, (b) that’s what inflation looks like anyway; it doesn’t manifest as smooth price changes across all goods at the same time, and (c) you still haven’t told me over what period it will take for this equilibrium to occur. Suppose it takes 5 years, and the average price change over that time is 5%. Does that mean it was transitory? Absolutely. Does that mean we should ignore it in that case? Absolutely not! A 25% change in the price level over five years would mean significant adjustments in product, service, and asset markets; significant volatility in operations of all sorts of businesses that have made long-term bets on inflation (insurance companies with long-tailed lines, e.g.); and significant changes in expectations and consumer behaviors.

If what they mean is “there is no general underlying process of inflation that will push all prices higher in synchronicity, so prices will eventually go back to flip-flopping around with some average tilt higher (say, 2% just to choose a number)” then the hypothesis is theoretical, and more importantly unfalsifiable.

If they mean something specific, such as “core inflation will average 3% for two years and then go back to 2%,” then they should say so. But they won’t, and you know why? They haven’t the faintest idea how long it will take, or how high it will get. And they didn’t see it coming in the first place, after all. And anyway, now that they are using “average inflation targeting” (with no stated target, at no stated distance) they don’t really care. What they do care about is that we all believe that these price changes are “transitory,” because then we won’t panic or slip the anchor of our inflation expectations.

Of course inflation will come back down again. In my view, it will come down in 2022, but from a significantly higher level than we are at; the subsequent low will probably not be below the Fed’s target, and the next high will be alarming to them. Because I think they can stomach almost any level of inflation as long as they believe it’s a semi-permanent high. If it’s just a local maximum, that will concern them. But notice, we’re talking about half a decade from now. Or, maybe it’s sooner. Heck, I don’t have to have the time frame nailed down – I’m not the one claiming it’s “transitory.”

So, lumber futures are falling now, after spiking higher. Resin prices have come down after spiking higher. Does that mean these were ‘transitory’ effects? If we were at the beach, we would describe each wave as transitory. But we would also want to know if the tide was coming in, or going out, when we set up our beach chairs. If it’s me? Right now I am setting my chairs a good distance away from the water.

Categories: Uncategorized

Summary of My Post-CPI Tweets (May 2021)

May 12, 2021 1 comment

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

  • Nice, sunny morning for #CPI here in the Northeast. Get ready for some fireworks today! I honestly can’t remember a time when a wider range of potential prints was not only possible, but plausible.
  • Last month, we saw a significant upside surprise as core inflation came in at +0.34% m/m. Yet, at some level this isn’t a surprise to those of us who are buying things.
  • What was really interesting about last month is that some of the big movers we expected – most notable among them used cars – did nothing special (Used Cars rose 0.55% m/m, yawn).
  • And yet, the upside surprise was also not in housing. Rents remained soft (more on that in a minute). So Median CPI, which we focus on more, was actually only +0.15% m/m.
  • Think about that…what that means is that the inflation surprise last month was due to large moves in smaller components – ones that no one expected to jump. If that doesn’t describe what inflation feels like in the real world, I’m not sure what does.
  • So turning to this month and the months ahead. We’re still waiting for rents (both primary rents and OER) to reflect the heat in the housing market and in the meteoric rise in asking rents.
  • My premise is that the abrupt and unusual divergence here is caused largely by the CDC’s eviction moratorium from last August, which has been extended several times – but which was recently vacated by a judge as being an overreach by the CDC.
  • I don’t know if that’s the last word, but in any case I wouldn’t expect that to have an effect THIS month. If we see a larger rise in rents, it’s organic from the general frothiness in housing and probably not from this effect, yet.
  • Also, we’re watching for used cars to catch up to private surveys. That’s a huge effect. Used Cars is 2.75% of the CPI, and New Cars has also seen upward pressure (it’s another 3.75%). That could easily add 0.1%-0.2% to core this month by itself.
  • There are lots of other places we may see pressure. There are shortages of containers, shipping, drivers, packaging, semiconductor chips, cotton, chlorine, ketchup, lumber, and the list goes on. Many of those categories are upstream to a LOT of consumer products.
  • Moreover, let’s not forget that there is a shortage of labor in certain sectors of the service economy. We haven’t gotten the Atlanta Fed Wage Tracker this month, but Average Hourly Earnings showed a big jump. That also feeds into consumer prices.
  • So economists this month are calling for 0.3% on core CPI, which thanks to base effects would move y/y to 2.3%. Given the usual CPI/PCE spread, that means we’d basically be at the Fed’s long-term target, FWIW.
  • This is much better than last month’s guess from the economists’ models, but with used cars alone I think you ought to be looking for that much. There are forecasts out there for +0.4% and even a few at +0.5%. Big shops, not people looking for notoriety.
  • That’s really not crazy at all. In fact while the Street consensus is 0.3%, the inflation derivatives market is closer to 0.4% as the NSA print traded yesterday several times around 265.9 (0.1% higher than the economists’ 265.6 guess).
  • Last month, the interbank market was also 0.1% higher than the economists, and they were right. FWIW the inflation market feels long to me, but there’s a lot of slower money at play too so the usual hedge-fund-flush MAY not necessarily follow any disappointment.
  • Regardless of what happens, the Fed will say transitory, and perhaps they are right. But either way, it’s economic volatility and that benefits no one (unless you’re long convexity). Not investors, and certainly not consumers. Good luck out there. 8min until #CPI.

  • Bug, meet windshield.
  • Core CPI +0.92% m/m. Yes, you read that right. Waiting for someone to say misprint. 2.96% y/y.
  • Incredibly this has nothing to do with rents. That’s amazing. A big move like that in core…hard for it not to involve rents. Primary Rents +0.20% m/m. OER +0.21% m/m. Ham-on-rye rent numbers as they say.
  • But Used Cars were +10.0% m/m, which means that series basically caught up to the private surveys in a single month. The good news is that removes some of the dry powder for future months.
  • These charts are comical. This is core goods (+4.4% y/y) and core services (a mere +2.5%).
  • The last time Core Goods was as high as +4.4% y/y was in 1991.
  • Airfares +10.2% m/m, which is part of that services jump. Lodging away from home +7.7%. Those are Covid/reopening categories.
  • Apparel as a whole was +0.32% m/m. It’s a small category but I’d been wondering why it had been so tame given that there was an embargo on certain Chinese cottons – I would have thought we’d have seen more.
  • In Medical, Pharmaceuticals were +0.63% m/m; Doctor’s Services ebbed a bit (-0.29% m/m) and Hospital Services was tame (+0.18% m/m).
  • A lot of my tweets are proceeding slowly because I have to check the numbers. Plus all of the charts re-scaled. Core ex-shelter is +3.57% y/y. Hasn’t been over 2% since 2012. Not over 3% since 1995.
  • OMG I buried the lede. Core CPI isn’t quite at 3%, though it rounded there. It hasn’t been ABOVE that since 1995. A quarter-century.
  • Core ex-shelter.
  • Sorry for the lag folks. My computers are literally throwing up on this data.
  • Interestingly, CPI for New Cars was only +0.26% m/m. In New Cars, there’s simply a shortage brewing but sticker prices haven’t risen very much. I think that’s a “yet”. The shortage is due partly to the shortage of chips of course.
  • OK, I am going to have to stop this here without a whole bunch of other stuff that is going to be great to look at…when my java/SQL connection decides to work. Here’s the bottom line though:
  • Core inflation at +0.9% is so outrageous that ironically the Fed will have an easier time ignoring it for now. And there were some things that we expected to catch up over multiple months, that caught up all at once. BUT there are also some things yet to come. >>
  • If primary and OER rents catch up merely to where they ought to be given historical relationships to asking rents, home prices, etc, then that’s another 1% or thereabouts on core CPI. And that’s harder to assume away than a used car spike. >>
  • But what we know is that next month, we will have the first core CPI y/y above 3% in more than a quarter-century. Because we still have one more easy comp from May. But we always knew this would be hard to read – and the smoke won’t clear until late this year.
  • Transitory? Better hope so. If not, look out below on stocks and bonds. That’s all for today. Thanks for tuning in and sorry I didn’t have more of my usual charts. If I get stuff working I may post them later.

Today’s month-over-month core CPI reading was the largest monthly figure since…wait for it…1981. That’s right, four decades ago. Yes, some of these things are going to be transitory. But they’re also going to be reprogramming consumers’ expectations. I’ve never been a big fan of the idea of anchored inflation expectations but as I wrote recently in “Once Again, You Ain’t Getting No Coke” whatever behavioral anchor there may have been is definitely threatened when there are large changes in prices.

Now let me add back a couple of the charts that I normally include, and maybe a couple of others. Here are the four-pieces charts. Each of these pieces is 1/5th to 1/3rd of the CPI consumption basket. There are lots of ways to cut the data but this is one I find useful. The first piece is Food & Energy. Little noticed in all of the craziness about core is that food and energy prices are also increasing markedly. Indeed, some food prices are rising as fast or faster than they did back when rising food prices helped spark the “Arab Spring.” Are we surprised at the unrest in Gaza? Get ready for more of that.

Second piece is core goods. Big piece of this is used cars. Kind of strange that new cars haven’t yet shown much of an uptick. The driver (no pun intended) of used cars is not just the huge tide of money of course, but also the smaller stock of used cars since rental fleets last year were shrunk a lot due to COVID. And rental car fleets are a big source of used cars.

Core services less rent-of-shelter is the third piece. Airfares, lots of personal services like child care, moving and storage, domestic services, etc. In a way, that’s a surprising piece here since this isn’t a raw materials gig, at least directly. But these services use packaging materials, cleaning materials, and other items whose prices are rising – and so are wages.

Finally, Rent of Shelter. The big bounce here is in Lodging-Away-from-Home, which was part of what was dragging it down. But rents themselves remain soft in the CPI, which I have to repeat is at odds with lots of the other ways we measure the cost of housing. This doesn’t mean that the CPI is ‘manipulated’; these discrepancies arise from time to time and we have a good reason to believe this is related to the eviction moratorium. I’m very confident rents will reconverge higher.

Now, because housing hasn’t lurched higher yet the median inflation figure will not be too bad. +0.3% m/m or so is what we’re likely to see, raising y/y to 2.17% or so. To be sure, +0.30% on median CPI is a big number for that series but not unprecedented. So today’s report is one reason that I always admonish people to look at median, not core. Core inflation is not going to rise at 11% this year. But remember the microwave-popcorn analogy: these one-off anecdotes are the way inflation is really experienced in practice. Maybe not 50% increases in used car prices, but a pop here and a pop there. This shows up as fatter tails on the high side of the distribution as opposed to the low side of the distribution when we are in a disinflationary environment. In an inflationary environment, we expect core inflation to be above median inflation because of those recurring “one-off” events. And, for the first time in a very long time, it is.

Finally, one more chart here and that’s of the EI Inflation Diffusion Index, which attempts to measure how widespread price increases are. It just peeked above zero for the first time since 2012. It keeps more distribution information than the median does, which is why it tends to rhyme with median but sometimes diverges.

Now let me sum up: the Fed doesn’t care. Oh, I am sure there are people at the Fed who will be alarmed, but the bottom-up people will see anecdotes and long-tails and not be worried. It’s the top-down people who are alarmed: the people who see money growth over 20% and have been bracing for what has historically always accompanied such money growth. But those people have no voice at the Fed. The main power around the table is concerned about making sure the unemployment rate is as near zero as possible. It’s an odd reversal from the Greenspan (and earlier) days, when the Fed believed that the way to maximize employment in the long run was to hold inflation low and steady. The Federal Reserve today behaves as if the best way to hold inflation low and steady in the long run is to maximize employment in the short run. That’s obvious nonsense, but here’s the important point: the crazy volatility of the economic data around COVID and in the base effects post-COVID create a fog of war that means it will be late 2021, and maybe even into 2022, before it will be clear to everyone that inflation is really settling down at a level higher than it was pre-COVID. Before then, the stock and bond markets are likely to discount worse price/rate conditions, which if anything will trigger even looser policy from the central bank.

In other words, by the time the Fed decides that cooling off price increases is more important than goosing the economy or the stock market, we will be very far down the road of squandering the Volcker Dividend. Behave accordingly.

Categories: Uncategorized Tags: ,

Once Again, You Ain’t Getting No Coke

April 27, 2021 6 comments

For a long time, I’ve held the opinion that the notion of “anchored inflation expectations” was an absurdity. For one thing, we have no good way to measure inflation expectations: market-based measures don’t reflect consumer expectations, and survey measures are nonsense that mostly reflect an availability bias (i.e., changes in small, frequently-purchased items, especially gasoline, have a much larger impact than large, infrequently-purchased items). There are lots of other biases in inflation perception, some of which I enumerated and discussed in a scholarly-ish article almost a decade ago.

It isn’t that I think that people don’t have inflation expectations, or that they are ‘wrong’ in some sense. It is just that the notion that they are “anchored” is something that is completely unmeasurable and so hypothetical. But many economists believe that hypothesis is necessary to help explain the break in inflation models around 1992-1993. I think there are better explanations for that break, which don’t require assuming a can opener.

However, recently I have started to reconsider whether there is a way in which behaviors concerning inflation are at least sticky. This is not to say that I think this necessarily has a role in inflation modeling (importantly, because there’s no good way to measure it), but I have definitely seen anecdotally some behaviors that can only be explained by figuring that consumers and producers become at least conditioned to expect low and non-volatile inflation. (Note, if I’m right about it being a conditioned response rather than an anchoring with respect to “strong central bank messaging,” it is useless in explaining the 1992-93 inflation model break because my hypothesis is that it takes a long time to happen).

My thoughts derive from some direct observations I have of actual producer/supplier behavior, from customers of mine and their suppliers, over the last couple of years but especially in response to the latest spike in raw materials prices. When I first began this sort of risk and pricing consulting a few years ago, I was struck at the attitude that one of my customers seemed to have – the customer behaved as if it was a commodity producer facing extremely elastic demand curves, such that they were very convinced that if they raised prices at all, they would lose a huge amount of their business to suppliers in China and India. Their customers of course reinforced this notion by responding to questions about price by saying that “lower prices would be good.”[1] But their product was both higher quality and shorter lead time than that of the competition; yet, they priced it as if only price mattered to their customers. The important point, though, is that they were conditioned to believe that any increase in price would destroy their business.

Their attitude wasn’t unique. Until recently you could see that behavior all over. To a surprising degree, diners with printed menus (with pictures!) have tended in recent years to have prices pretty much hard-coded and printed onto the menu. Your local barber probably changed prices every five years, at most. And every change was usually accompanied by an explanation to the customer about the need for higher prices for one reason or another. It is a strange dynamic, very different from what you see in an inflationary regime, such as in this classic scene from the movie Caddyshack (released in 1980):

Tony D’Annunzio: Give me a Coke.

Danny Noonan: One Coke.

[gives Tony a bottle of Coke and 50 cents]

Tony D’Annunzio: Hey wait a minute. That’s only 50 cents.

Danny Noonan: Yeah, well, Lou raised the price of Coke. He’s been losing at the track.

Tony D’Annunzio: Well I ain’t paying no 50 cents for no Coke.

Danny Noonan: Oh, then you ain’t getting no Coke!

Instead, in this era of low and stable inflation it looks and feels like suppliers have learned “anchored” behaviors. “I can’t raise prices; all of my customers will leave.”

Fast forward to the COVID crisis.

Input costs for many producers have skyrocketed. For example, the price of polypropylene has roughly tripled since the lows last summer. Yes, at least part of that is temporary. Up until about six months ago, when movements in input costs induced changes in profitability for producers they would hold the line on prices, lest they lose a bunch of business, and watch their margins decline. Ultimately, when input costs retraced, they would enjoy wider margins again. Price changes were artificially muted because the supply chain dampened price fluctuations. The producer absorbed those costs because of the perceived elasticity of end product demand.

However, the volatility of input prices recently has been such that producers couldn’t absorb all of the costs into margin and still remain viable. Some of the suppliers and competitors to the client I mentioned above did indeed hold prices as long as they could, before eventually passing them on with great apologies. I advised my client, though, to pass cost increases through immediately. Some in management wanted to label the increase a “surcharge,” but that again is an apologetic way to adjust prices – and one you do need to justify. Instead, they jacked up their prices to maintain their margins, and braced for the worst.

And lo and behold…nothing happened. Some customers wanted an ‘explanation’ for why the price of the Coke went up, and some customers complained that the Coke was cheaper elsewhere. Ultimately, my client did just as much business after the price increase as they did before the price increase.

What they learned, and what lots of suppliers, restauranteurs, and others are learning, is that demand is not as elastic as they had thought; that everyone wants a lower price but they’ll pay for the value of the product if they need the product. That, with more money in the system, raising prices a little doesn’t hurt business very much at all. If you need a Coke, you’ll pay the fifty cents for a Coke even if you wish it was still forty cents (and part of the reason you will pay without much complaint is because you just got $1,600 from the government for no reason at all).

Watching this behavior is what makes me wonder about the anchoring of inflation expectations. Again, I think of this as a conditioned behavioral response. By the same token, though, people can unlearn these conditioned responses. We are all conditioned now to put on a mask when going into a restaurant, but we will (hopefully) unlearn that behavior and the new conditioning will be to not put on a mask when entering a restaurant. That’s what’s happening now, I think, to suppliers in many industries. I think they’re all surprised, but I also think they’ll remember. It’s just one of many reasons I think that regardless of the path inflation takes over the next decade, it will likely be both higher on average and more volatile as well. Take away the “anchor” and the ship tosses about more, and moves with the tides. I don’t really know of a good way to model this, and I am also fairly confident that the Fed will not recognize that the anchor has been slipped (which means bad things in expectations-augmented Phillips Curve models!) for a while. To be clear, I don’t think the lack of policy response to the un-anchoring matters much because I don’t think the Fed had very much to do with the conditioning in the first place and expectations won’t become “re-anchored” merely because of the central bank’s messaging. I guess I don’t really think the central bank’s messaging means as much to consumers as they think it does! In any event, it takes time for conditioning to take hold, but less time I think for the conditioning to be broken.


[1] One of my first recommendations was that they stop asking this question. What do you expect customers to say, that they want higher prices? The question is whether they will not buy your product at a higher price, and asking their opinion on that is a really bad way to find out the answer.

Categories: Uncategorized

Some Thoughts on Gold, Real Yields, and Inflation

February 23, 2021 6 comments

TIPS-style inflation-linked bonds (more properly known as Canadian-style) pay a fixed coupon on a principal amount that varies with the price level. In this way, the real value of the principal is protected (you always get back an amount of principal that’s indexed to the price level, floored in the case of TIPS at the original nominal value), and the real value of the coupon is protected since a constant percentage of a principal that is varying with the price level is also varying with the price level. This clever construction means that “inflation-linked” bonds can be thought of as simply bonds that pay fixed amounts in real space.

I have illustrated this in the past with a picture of a hypothetical “cake bond,” which pays in units of pastry. The coupons are all constant-sized cupcakes (although the dollar value of those cupcakes will change over time), and you get a known-sized cake at the end (although the dollar value of that cake might be a lot higher). That’s exactly what a TIPS bond is essentially accomplishing, although instead of cupcakes you get a coupon called money, which you can exchange for a cupcake. This is a useful characteristic of money, that it can be exchanged for cupcakes.

The beauty of this construction is that these real values can be discounted using real yields, and all of the usual bond mathematics work just perfectly without having to assume any particular inflation rate. So you can always find the nominal price of a TIPS bond if you know the real price…but you don’t need the nominal price or a nominal yield to calculate its real value. In real space, it’s fully specified. The only thing which changes the real price of a real bond is the real yield.

All TIPS have coupons. Many of them have quite small coupons, just like Treasuries, but they all have coupons. So in the cake bond, they’re paying very small constant cupcakes, but still a stream of cupcakes. What if, though, the coupon was zero? Then you’d simply have a promise that at some future date, you’d get a certain amount of cake (or, equivalently, enough money to buy that certain amount of cake).

Of course, it doesn’t have to be cake. It can be anything whose price over a long period of time varies more or less in line with the price level. Such as, for example, gold. Over a very long period of time, the price of gold is pretty convincingly linked to the price level, and since there is miniscule variation in the industrial demand for gold or the production of new gold in response to price – it turns out to look very much like a long-duration zero-coupon real bond.

And that, mathematically, is where we start to run into problems with a zero-coupon perpetuity, especially with yields around zero.


[If you’re not a bond geek you might want to skip this section.] The definition of Macaulay duration is the present-value-weighted average time periods to maturity. But if there is only one “payment,” and it is received “never,” then the Macaulay duration is the uncomfortable ∞. That’s not particularly helpful. Nor is the mathematical definition of Modified duration, which is Macaulay Duration / (1+r), since we have infinity in the numerator. Note to self: a TIPS’ modified duration at a very low coupon and a negative real yield can actually be longer than the Macaulay duration, and in fact in theory can be longer than the maturity of the bond. Mind blown.  Anyway, this is why the concept of ‘value’ in commodities is elusive. With no cash flows, what is present value? How do you discount corn? Yield means something different in agriculture…


This means that we are more or less stuck evaluating the empirical duration of gold, but without a real strong mathematical intuition. But what we think we know is that gold acts like a real bond (a zero coupon TIPS bond that pays in units of gold), which means that the real price of gold ought to be closely related to real yields. And, in fact, we find this to be true. The chart below relates the real price of gold versus the level of 10-year real yields since TIPS were issued in 1997. The gold price is deflated by the CPI relative to the current CPI (so that the current price is the current price, and former prices seem higher than they were in nominal space).

When we run this as a regression, we get a coefficient that suggests a 1% change in real yields produces a 16.6% change in the real price of gold (a higher yield leads to a lower gold price), with a strong r-squared of 0.82. This is consistent with our intuition that gold should act as a fairly long-duration TIPS bond. Of course, this regression only covers a period of low inflation generally; when we do the same thing for different regimes we find that the real gold price is not quite as well-behaved – after all, consider that real gold prices were very high in the early 1980s, along with real yields. If gold is a real bond, then this doesn’t make a lot of sense; it implies the real yield of gold was very low at the same time that real yields of dollars were very high.

Although perhaps that isn’t as nonsensical as it seems. For, back in 1980, inflation-linked bonds didn’t exist and it may be that gold traded at a large premium because it was one of the few ways to get protection against price level changes. Would it be so surprising in that environment for gold to trade at a very low “gold real yield” when the alternative wasn’t investible? It turns out that during the period up until 1997, the real price of gold was also positively related to the trailing inflation rate. That sounds like it makes sense, but it really doesn’t. We are already deflating the price of gold by inflation – why would a bond that is already immunized (in theory) against price level changes also respond to inflation? It shouldn’t.

And yet, that too is less nonsensical as it seems. We see a similar effect in TIPS today. Big inflation numbers shouldn’t move TIPS higher; rather, they should move nominal bonds lower. TIPS are immunized against inflation! And yet, TIPS most definitely respond when the CPI prints surprise.

(This is a type of money illusion, by which I mean that we are all trained to think in nominal space and not real space. So we think of higher inflation leading to TIPS paying out “more money”, which means they should be worth more, right? Except that the additional amount of dollars they are paying out is exactly offset by the decline in the value of the unit of payment. So inflation does nothing to the real return of TIPS. Meanwhile, your fixed payment in nominal bonds is worth less, since the unit of payment is declining in value. Although this is obviously so, this ‘error’ and others like it – e.g. Modigliani’s insistence that equity multiples should not vary with inflation since they are paying a stream of real income – have been documented for a half century.)

For now, then, we can think of gold as having a very large real duration, along with a price-level duration of roughly one (that is just saying that the concept of a real price of gold is meaningful). Which means that higher inflation is actually potentially dangerous for gold, given low current real yields, if inflation causes yields (including real yields) to rise, and also means that gold bugs should cheer along with stock market bulls for yield curve control in that circumstance. Inflation indeed makes strange bedfellows.

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