Posts Tagged ‘inflation’

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: ,

How Many ‘Shortage’ Anecdotes Equal Data?

March 30, 2021 3 comments

There is a growing list of categories of prices which are seeing abnormal price pressures. At least, they are abnormal by the standards of the last quarter-century! A couple of months ago, in “The Risk of Confusing Inflation Frames,” I wrote about some of the effects we might soon be seeing, and of the risk that some of the known-but-temporary effects will obfuscate more serious underlying issues.

In April, we will get the CPI for March; this will be the first CPI release to have ridiculously easy comparisons against the year-ago month. March 2020 was -0.2% on core CPI, and I suspect the consensus estimate for March 2021 will be something like +0.2%; this implies the y/y core inflation number will jump from 1.3% to around 1.7%, depending on rounding. But as I said, that disguises some of the important underlying pressures that may also start to appear with this number. There is an old saying that the plural of “anecdote” isn’t “data,” but eventually there must be a crossover point where the preponderance of independent anecdotes begins to approach the informational value of data, right? Well, here is a short list of some recent anecdotes and reports of shortages.

There has become an acute shortage of semiconductor chips, which has impacted automobile production (and will that increase prices for what is available?). There is a shortage of shipping containers, causing widespread increases in freight costs affecting a wide variety of goods. Packaging materials, which are also a part of the price of a great many goods, are also shooting higher in price. Worker shortages at various skill levels were reported in the most-recent Beige Book. There is a shortage of Uber and Lyft drivers.

There are other effects that have shown up but I misapprehended the significance of them at the time. Apparel prices have risen at an annualized 9% pace over the last four months. I’d attributed that to shipping, but there is more to it than that. In January US Customs issued a Withhold/Release Order (WRO) on cotton and tomato products coming from the Xinjiang region of China, where forced labor is employed; the order calls for the stoppage of freight with any amount of cotton (or tomatoes, but there is not much tomato in apparel) that originates from that region – even if it is only the thread on the hem. While this and the other effects on apparel are probably temporary, we don’t really know how temporary.

Importantly, we should add to these shortages a growing shortage of housing. The inventory of homes available for sale just hit an all-time low (the National Association of Realtors started keeping track in 1982).

And, as a result, the increase in the median sales price of existing homes just reached an all-time high spread over core CPI (home price increases sometimes have been higher, though it is unusual. For example, in May 1979 the year-over-year increase in the median home price was 16.9%. But core inflation was 9.4% at the time, so the real increase in home prices was only 7.5%).

I have written elsewhere about the fact that there is large divergence right now between what the BLS indicates the effective inflation in the cost of housing is, and what a measurement of asking rents suggest it should be. The significant chart is reproduced below – and the short story is that the divergence dates to the imposition of the COVID-related eviction moratorium. This has decreased the amount of rent that landlords actually expect to receive on average, which lowers effective rents even though every other measure of the true (free market) cost of shelter would be, is ratcheting higher at rates seldom if ever seen before.

Now, this moratorium was due to expire at the end of March, but the CDC just extended it until June (which may be one reason that TIPS breakevens have hit some minor resistance). That’s a little unfortunate since it means that the moratorium will expire right about the time that the CPI is enjoying favorable comparisons versus 2020. The understating of rent and owners’-equivalent rent inflation, since those are a huge portion of the consumption basket, has an outsized effect on CPI. I want to be fair here to the BLS: in an important sense, the CPI data on rents is not wrong because in fact if a tenant pays less because of the moratorium, then that tenant’s cost of living really did go down. Even though in a free market without such a moratorium his cost of living would have been higher, that’s not the question the BLS is trying to answer. The cost of living is lower in such a case. Of course, that’s temporary, and so when the moratorium is lifted we can expect the BLS will also faithfully report the catch-up. Which means that in the summer, when we would have expected y/y CPI to start to decline again as it faces more difficult comparisons to 2020…it may not, because rents will start to catch up. That’s going to toast the marshmallows of a lot of investors.

Now, there’s one more facet of the cost-of-shelter question and that’s whether home prices have risen too far, too fast and so it’s home prices and asking rents that will have to decline, rather than effective rents re-accelerating. This is a reasonable question. It is true that the ratio of home prices relative to incomes is getting back to levels that in the late 2000s indicated a bubble was getting ready to pop (see chart). For many, many years median home prices relative to median incomes was fairly stable at around 3.4x. Some increase makes sense since homes have been getting bigger, but it does give the appearance of being overextended.

However, last week in Money Illusion and Boiling Frogs I argued that the nominal value of certain real assets might be usefully compared to the level of the money supply as a way of assessing their real value. Comparing the equity market to M2 made the former look less frothy, and the argument is that maybe equity investors aren’t suffering from “money illusion” in the same way that consumers might be (so far). But the same cannot be said for the housing market. The chart below (Source: Bloomberg) divides the home price index (from the FHFA) by M2. While home prices relative to incomes look high, home prices relative to the stock of money look quite low. It is interesting how the QE of the early 2010s shows up as a one-time shift in this ratio, followed by a period of stability, isn’t it? It suggests that maybe home prices didn’t fully adjust to the new money-stock reality after the bubble’s burst in 2008 and the subsequent QE. And maybe such a one-time shift happens again now.

But it might also be the case that the current rapid escalation of home prices is the market’s attempt to get the real value of the housing stock to reflect the rapidly increasing value of the money stock. If that’s the case, then it also suggests that median wages probably will eventually follow. The last people to respond to money illusion generally are the people selling their labor.

I don’t know if this is the ‘right’ answer, and my purpose in these articles isn’t to give the ‘right’ answer. I just want to ask the right questions…and I feel like these are the right questions.

Categories: China, CPI, Housing, Wages Tags: ,

Summary of My Post-CPI Tweets (February 2021)

February 10, 2021 Leave a comment

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

  • But landlords have been collecting less rent, and expecting less rent, and so in the BLS calculation this shows up as less growth in rents. But it’s also cyclical.
  • It does look to me like rent collections stayed soft in January but it’s hard to tell a priori. Anyway that’s the story with rents and we’ll watch that.
  • Outside of rents, it’s a different story. On the services side, still soft especially in medical. And that still confounds me. How is medical inflation so low with a medical crisis on our hands? Head-scratcher.
  • On the goods side, we have pressure in pharma coming from price hikes from some major manufacturers in Jan (more than usual seasonal), and we have a GENERAL CRISIS on the supply side.
  • Shipping rates have skyrocketed. Raw goods prices have been rising rapidly.
  • It’s weird to say keep an eye on apparel, because it’s a small weight and has rarely been anything but soft for years. But apparel uses fabric and lots of fabric uses resin. And resin has tripled in price over the last couple of months. And most apparel is imported.
  • Anyway, core goods should stay robust.
  • What that means for overall core CPI is hard to say. As I wrote recently (and it’s worth reading), there are a lot of  conflicting frames right now:
  • The ‘fog of war’ will make interpreting this number very hard for the next 6-8 months. Which means policymakers will easily ignore it no matter what it does, even though the #Fed doesn’t care about inflation.
  • But if YOU care, and have interests in how to hedge/invest in the inflationary period approaching, visit
  • That’s all for now. Good luck. The consensus estimate is +0.17% on core, keeping the y/y at 1.5% (rounded down). I will look at ex-housing and think there’s some upside there. We’ll see.
  • Well this breakdown will be fun. Core CPI flat (waiting on BBG to post the actual number so we can see how flat).
  • OK, 0.03% on Core. Y/y 1.40%.
  • Apparel +2.21% m/m. Like I said, that’s only 2.8% but all of the supply issues converge on that category. Apparel is still -2.57% y/y.
  • Primary Rents +0.11% for second month in a row. OER +0.14% for the second month in a row. Neither is sustainable when home prices are spiking. Y/Y is 2.05% and 2.01% respectively.
  • Lodging Away from Home, a “COVID Category” -1.88% m/m. So I think we can see Shelter was a big softee.
  • Other COVID categories: airfares -3.18% after -2.46% last month; Used Cars & Trucks -0.89% after -0.90% last month. But Motor Vehicle Insurance +1.13% after +1.42% last month.
  • In Medical: Medicinal Drugs -0.25% m/m after -0.24%. That makes little sense. Although seasonally we expect price hikes in January, there were many more price hikes this year than in a typical year.
  • This number is weird all over in that many m/m changes are almost identical to last month’s changes.
  • Doctor’s Services +1.55%, Hospital Services +0.27% m/m. That’s good to see. I mean, I support doctors.
  • So overall, core services dropped from 1.6% y/y to 1.3% y/y (!) while core goods stayed at 1.7% y/y. I rather expected the latter to rise, especially with the apparel jump, so will have to dig deep on that one.
  • So core CPI ex-shelter dropped from 1.45% y/y to 1.25% y/y.
  • Let’s see…biggest declines m/m (in core) were Lodging Away from Home (-20% annualized), Public Transport (-18%) (?), Car and Truck Rental (-12.2%), Misc Personal Services (-11.4%) and Used Cars and Trucks (-10.2%). Lots of mobility stuff there!
  • Biggest core gainers: Jewelry & watches (+62% annualized), Women’s/Girls Apparel (+44%), Tobacco/Smoking (+24%), Motor Vehicle Insurance (+21%), Footwear (+18.8%), Men’s/Boys apparel (+19%). Lots of imports/manufacturing there!
  • Because of the weakness in rents, Median CPI might actually be negative this month. That’s rare! Last year when core CPI was negative three months in a row, median never went below +0.12% m/m.
  • So, again, I’m not really worried about rent going to zero here. What we’re measuring is an accelerating underlying trend in asking rents plus a cyclical underlying trend in delinquencies. The latter will fade.
  • Of course, I could be wrong. Maybe home prices will collapse. But the divergence doesn’t make a lot of sense. These are substitutes!
  • I guess at the end of the day (I hate that term) this report is only surprising in magnitudes.I expected rent might be soft, just surprised at how soft. Expected apparel to jump; it did. I guess Pharma prices were surprising. The rel strength of goods v svcs wasn’t surprising.
  • Meanwhile, back in the market…10y breakevens don’t like this report; they’re down 1.75bps. But not sure anything here will change minds.
  • After all, the market is already pricing in very low core inflation for the next few years. And 10y inflation isn’t exactly trading at a premium. You’re not overpaying for the chance that inflation has a long-tail outcome to the upside.
  • Four pieces. First CPI pie piece: Food & Energy.
  • Second piece, and the ongoing story, is core goods inflation. Now above core services, with or without shelter.
  • Core services less rent of shelter. Here is where the mobility stuff is dragging us down. One hopes this comes back once mobility comes back.
  • And piece 4, what will be endlessly debated: rent of shelter, including lodging away from home. Be careful comparing to the GFC – that was, after all, a housing crisis with collapsing home prices. Made perfect sense then. Makes very little sense now; I don’t see this persisting.
  • I think it’s worth touting my own article again, The Risk of Confusing Inflation Frames. There are lots of crosscurrents here, ‘fog of war’ stuff, will make it hard to discern true trend.
  • Rent collections soggy, resin prices up several hundred percent. But meanwhile, there is this. The fog is going to obfuscate any underlying upward pressure on the price level. But I’m really confident that if you increase the global money supply 20%, you don’t get less inflation.
  • One more comment on those lines. Next month’s comp on core CPI is +0.22% from Feb 2020. And that’s the last pre-covid comp, which means it will then be a long time before we have a clean picture. In between there may be a state shift that’s hard to see. Be careful.
  • That’s all for today. Thanks for following and retweeting etc. A summary will be up on  in a little while (linked too from ) and will make its way around to other sites thereafter. Have a good day!

I don’t have a lot to add to this that I haven’t already said in the “Frames” piece. There are a lot of crosscurrents here and the comforting thing this month is that they’re the crosscurrents we expected to see! I was surprised at how soft the number was, but if you’d given me the rents numbers I would not have been. One thing I forgot to mention as a driver of apparel isn’t just resin and freight, but also cotton which has been rallying hard for a while too. But this is playing to form.

The question about whether we should be measuring asking rents or actual paid rents is interesting. The CPI is supposed to measure the average prices of what consumers on average consume. And the average rent is clearly declining if more people are paying zero. But since most people aren’t paying zero, the change in the median rent is a better indicator of what most renters will see. Over a full cycle, the differences will smooth out because once eviction moratoria are removed and Americans are mostly back to work, the number of zero renters will decline. But for now, this just helps the conspiracy theorists argue why the BLS is saucing the number to make it low. However, I don’t think it’s wrong or intentionally misleading.

We have one more ‘pre-covid’ comp to see…and for most of the rest of the year after that, we’ll have to place our bets with blindfolds on.

Categories: Uncategorized Tags: ,

The Risk of Confusing Inflation Frames

February 4, 2021 8 comments

People who look at and talk about inflation are always having to move between multiple frames. There is the macro versus the micro, the theoretical versus experiential, and of course the short term, medium term, and long term. I spend a lot of time talking about the macroeconomic backdrop (27% money growth, weak velocity that should be recovering), and mostly address the short-term effects when I do the monthly CPI analysis on Twitter (and summarized here, for example this one from last month). And occasionally I do a one-off piece about more lasting effects (e.g. inventories).

But I rarely tie these things together, except quarterly for clients in our Quarterly Inflation Outlook. Right now, though, this is an exquisitely confusing time where all of these frames are colliding and making it difficult to make a simple, clear argument about where inflation is headed and when. So in this column I want to briefly touch on a number of these effects and tie the story together.

Short-term Effects

There are a bunch of short-term effects, or ones that are at least mostly short-term. We recognize that these are unusual movements in costs and prices, and expect them to pass in either a defined period (e.g. base effects) or over some reasonably near-term horizon. This makes them fairly easy to dismiss, and in fact these are not reasons to be fearful of inflation. They will affect CPI, and therefore they will affect how TIPS carry, but they should not change your view of what medium-to-long-term inflation looks like.

  1. Base effects – We know that last March, April, and May’s CPI reports were incredibly weak, as things like airfare and hotels and used cars absolutely collapsed. Core CPI declined -0.10% in March 2020, -0.45% in April 2020, and -0.06% in May 2020. These were followed by rebounds in some of those categories and in others, with June, July, and August core CPI at +0.24%, +0.62%, and +0.39%. What this means is that if core CPI comes in at 0.20% per month from here, then year/year core CPI will rise to 1.85% in April (when March 2020 rolls off), 2.52% in May, and 2.78% in June. But then it would fall to 2.32% in August (when July 2020 rolls off) and 2.13% in September. You’re supposed to look through base effects like that, and economists will. The Fed will say they’re not concerned, because the rise is mainly base effects – even if other things are going on too. Behaviorally, we know that some investors will react because they fear what they don’t know that is behind the curtain. And that’s not entirely wrong. But in any event this isn’t a reason to be concerned about long-term inflation.
  2. Measurement things, like rents – Quite apart from the question of whether COVID has caused inflation (or disinflation) is the question of what COVID has done to the measurement of inflation. For example, in the early months of the pandemic the BLS made an effort to not try too hard to get doctors and hospitals to respond to their surveys. Not only were many surveyed procedures not actually happening, but also the doctors and hospitals were clearly in crisis and the BLS figured that the last thing they needed was to respond to surveys, so the measurement of medical care data was sketchy at least early on in the pandemic. And there were many other establishments that were simply closed and could not be sampled. Most of those issues are past, and the echo of them will be past once the March-August period is out of the data. But there are some that persist and the timing of the resolution of which remains uncertain. The most important of these is the measurement of rents, both primary rents (“Rent of Primary Residence”) and the related Owners’-Equivalent Rent. In measuring rent, the BLS adjusts the quoted “asking” rent on an apartment unit by the landlord’s assessment of what proportion of the rent will eventually be collected. So, even if a renter is late on the rent, a landlord who expects to eventually expects to receive 100% of the rent due will cause that unit to be recorded at the full rent.

During the pandemic, of course, many renters lost their incomes and many others recognized that eviction moratoria made it feasible to defer rent payments and conserve cash. As a consequence, measured rents have been decelerating as landlords are decreasing their expectations of eventual receipt, even as asking rents have been rising rapidly along with home prices. The chart below (Source: Pantheon Macroeconomics, from the Daily Shot) illustrates this point. The divergence is explained by the increase in expected renter defaults – and it is temporary. Indeed, if the federal government succeeds in dropping more cash into people’s bank accounts, it will likely help decrease those defaults and we could see a quick catch-up. (That’s actually a near-term upward risk to core inflation, in fact). But in any event this isn’t a reason to be concerned about long-run inflation or disinflation…although the boom in home prices, perhaps, is.

  1. Shipping Containers – Another item that is related to COVID is that shipping costs are skyrocketing. Partly, this is because shipping containers are in the wrong places (a problem which eventually solves itself); partly, it is because the stock of shipping containers is too small to handle the sudden surge in demand as businesses reopen and not only re-build inventories but also build them beyond what they were pre-COVID (see my article about inventories for why). Deutsche Bank had a note out yesterday opining that while this spike in shipping costs – see the chart of the Shanghei (Export) Containerized Freight Index, source Bloomberg, below – will eventually ebb, it may not go down to its long-term average. But, still, the majority of this spike in costs, which is felt up and down the supply chain and drives higher near-term inflation for everything from apparel to pharmaceuticals, will ebb and isn’t a reason to be concerned about long-run inflation.
  1. Raw Materials – The same picture we see in the Shipping Containers chart is evident in lots of other raw materials markets. I’m not speaking here as much about the large commodities complexes like Copper, Lead, Oil, and so on but about certain less-widely followed but no less important markets. One you may have seen is steel (see chart, below, of front Hot Rolled Steel futures), which have nearly tripled since the summer and are about 30% above 2018’s highs with no end apparent.

Closer to my heart, and one you’re less likely to have seen, is the chart of resin futures. This is polymer grade propylene, which is a precursor to polypropylene. PP is used in all sorts of applications, from clothing and other fabrics to packaging (soda bottles!) of all kinds. And North American supplies of PP are under what can only be called severe pressure. Front PGP has more than quadrupled since the spring, and is at multi-year highs (if you can find an offer at all). It’s up 142% since mid-December! And PP is up even more, as producer margins have widened. Folks who want to track this and related markets might start by visiting theplasticsexchange. The reasons for this spike are part technical, although caused by the sudden re-start of the global economies, and will eventually pass. As with shipping, it may not go back to what was “normal,” but in any case movements like this, or those with steel or other raw materials, are not reasons to be concerned about long-run inflation. However, they likely will affect CPI prints as these are inputs into all sorts of goods.

That is a non-exhaustive list of some of the short-term effects that are directly or indirectly related to the stop-start of the COVID economy. They will pass, but they add a tremendous amount of sturm und drang to the price system and can confuse the medium and longer-term impacts.

Medium-term Effects

Some of the medium-term things that are happening, and that matter, and that will last, will be missed. Here are a few on my list:

  1. Pharmaceutical prices – One of the really fascinating things we have seen over the last few years has been the slow deceleration in inflation of medical care commodities, specifically drugs. The chart below (source Bloomberg) shows the y/y change in the CPI for Medicinal Drugs. In late 2019, after slipping into deflation, drug prices appeared to find a footing and to be recovering. But even before COVID, this jump was starting to ebb and in the most-recent 12 months pharmaceuticals prices experienced their largest decline in decades. Why?

One reason this happened is because the Trump Administration threatened drug companies with a “Most Favored Nation” clause. This means that the drug companies would not be allowed to sell their products in the United States at a higher price than the lowest price they charged overseas. The Trump Administration said that this would cause massive decreases in drug costs; this clearly wasn’t true (for reasons I discussed here last August) but it would tend to cause drug prices to decline in the US at least a little, especially relative to other countries’ costs. Faced with this, drug companies played nice…until Mr. Biden won the Presidency, in at least small part because some of the large vaccine developers slow-rolled their vaccine announcement until after the election. In January, they started moving prices higher again. This may hit the CPI as early as this month. But unlike with the short-term effects listed above, this is not a response to COVID or its ebbing, and it isn’t something that is likely to change. The Biden Administration is much less antagonistic towards drug companies than the Trump Administration was. And by the way, it isn’t just the drug companies that fall in this category. (Insert snarky comment about Trump here.)

  1. I mentioned earlier my article about how inventory management is going to change as a result of COVID. Indeed, the fact that it is already changing is one reason that the supply/demand imbalance is so bad in the short run: as I have already said, companies are building back inventories and adding additional safety stock, and that is stressing production of all sorts of goods. That was a short-term effect but the more-lasting effect is that carrying larger inventories is itself more expensive. Inventory carrying costs increase the costs of goods sold (which is the main reason managers have been pushing them down for decades). Carry more inventory, prices go up more. I don’t think this trend will ebb.
  2. Another trend I’ve seen directly, and am comfortable generalizing, is a movement among manufacturers towards shortening supply chains. The problems with production during COVID, along with the aforementioned shipping tie-ups, argues for shorter supply chains and diversified country sources (don’t get everything from India, for example, in case India as a whole shuts down). Also, shortening supply chains means that inventories (see #2) can be a little lower (or rather, safer at any given level of inventory) since one of the drivers of inventory size is lead time. Customers seem willing, at least today, to pay up to get suppliers in the same hemisphere and even more to get them in the same country. Every purchasing manager noticed that in the depths of the COVID shutdown many countries toyed with the idea of completely closing borders; some countries required container ships to ‘quarantine’ offshore for a time before they could unload. No one expects another COVID, but the -19 version reminded everyone of how the fragility of the supply chain increases with distance. Because in this country, shorter supply chains imply higher costs (since production is still generally cheaper overseas, though that differential has shrunk a lot), this is a short-term level adjustment followed by a lasting upward trend pressure on pricing. It’s essentially a partial reversal of the globalization trend, which reversal had already begun in little ways under the Trump Administration.

Granted, much of this is manufacturing-focused and most of the consumption basket (thanks mostly to rents) is services. But for many years it had been goods inflation holding down overall inflation, until recently. In the last CPI report, Core Goods inflation moved above Core Services inflation for the first time in a long, long time. That looks more like the inflation we remember from the ‘70s and ‘80s, with a much broader set of services and goods inflating.

Macro-level Effects

The last frame I want to touch on is the macro, top-down inflation concern. I won’t spend much time arguing whether output-gap models are working…if they were, then we would be in heavy deflation right now and there would be no signs of inflation anywhere, so clearly that’s the wrong model…and merely point briefly to the now-well-documented surge in M2 money supply growth (see chart, source Bloomberg), which is currently 27% y/y in the US, 11% y/y in Europe, 14% y/y in the UK, and even 9.2% in Japan. The increase in the transactional money supply in the US is twice as large as anything we have ever seen in this country, aside perhaps from the very early days when “not worth a Continental” became a term of opprobrium. Some people have argued that since money growth in 2008-9 didn’t produce much inflation, we oughtn’t worry about it this time either. But the last crisis really was different, as it was a banking crisis  (I wrote about this almost a year ago).

So, unless central banks have been doing it all wrong for a hundred years, the bare intuition is that this much money supply growth probably won’t be a non-event. Money velocity, in the short term, plunged because (a) mechanically, cash dropped into bank accounts by a generous government takes some time to spend, and (b) understandably, the demand for precautionary cash balances got super high during COVID. Both of these are passing issues, and it takes some heroic assumptions to argue why money velocity should continue to decline. Not merely stay low: if money growth continues at the 27% pace of the last year or even just the 13%-16% pace of the last quarter, even stable money velocity would produce much higher prices.

Over time, the relationship of money to GDP is a great proxy for the price level. That model has been powerful for a hundred years, and it makes sense: increasing the money supply 25% doesn’t increase wealth 25%. The amount of things you can buy with that money doesn’t change very much. So the value of the measuring stick, the dollar itself, must be weakening since 25% more dollars buys the same amount of stuff. To be sure, that’s only if people spend the new dollars as fast as they spent the old dollars, so if there’s a permanent change in velocity this won’t be true. But it needs to be a permanent change in velocity, and outside of lowering interest rates we don’t have a great way to induce permanently lower velocity.

[As an aside, the same reasoning applies to asset markets rather than consumables. Because the real output of businesses, and the stock of physical assets, don’t change very fast, a large increase in money must increase the nominal price of those things (or, more accurately, decrease the value of the measuring stick). But how to account for a decline of the value of the dollar in purchasing financial assets, but no big decline in the value of the dollar for purchasing goods and services? This implies a change in the exchange rate between real goods and financial assets. That is, a person can exchange a Tesla for fewer shares of TSLA. But unless markets are permanently valued at higher multiples when the economy is flooded with cash (and there’s no sign that has happened before in the long sweep of history with episodes of rising money supply), eventually the price of shares must decline or the price of consumption goods rises, or both. Essentially, money illusion is operating in one sphere, but not in the other, and I think that’s unsustainable. Maybe I’ll write more about this another time.]

On the macro front, the alarm bells should be ringing very loudly.

So in the three frames above we have some effects that are easy to look through, and to ignore as temporary. We have some effects that are more subtle, but long-lasting. And we have some effects that are potentially huge, and haven’t come to the fore yet at least in the consumption basket. On the whole, the signs are compelling that inflation is very, very likely to rise in a way that is not just temporary. But, because these frames are confusing, and because the Fed (and others) will easily dismiss some of the one-off effects as temporary COVID effects – which they are – this is actually an acutely dangerous time for investors. The fog of war, provided by these short-term effects, will obfuscate some of the longer-term effects and ensure that policymaker response is late, halting, and inadequate. Markets, though, will be reacting in what some will call an exaggerated reaction. Indeed, some already believe that the rise of 10-year breakevens to near-two-year highs, at 2.17% today, is an overreaction.

I don’t think it is. We are going to see core inflation rise on base effects and one-offs, then decline on base effects, but probably not as much as people expect right now. That’s when the fog will begin to clear, and we will see inflation accelerating from a level that’s already higher than it is now. By the time the fog of war clears in late 2021 or early 2022, it will be late to start planning for inflation. Maybe not too late, but late. By the time everyone agrees inflation is a problem, the price of inflation protection will have moved a lot.

Summary of My Post-CPI Tweets (December 2020)

December 10, 2020 3 comments

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

  • Once again, it is #CPI Day! As the summer shutdown continues to recede (even as a winter shutdown potentially looms), the data is starting to clear up a little.
  • There are still huge dislocations, though, in the global supply chain and we’re seeing anecdotal evidence of that all over the place. Check out the price of polymer grade propylene if you don’t believe me. PGP1 Comdty on Bloomberg.
  • Container shortages are also causing price and quantity ripples in global trade. And of course, huge amounts of money chasing these fewer goods. y/y M2 is +25% in the US. 10% in Europe. 9% in Japan.
  • Often, I go into the CPI report with just a vague sense of looking at the whole number and then breaking it down. This month, I have a little different plan of attack.
  • The word of the day today is “compartmentalize.” There is housing, and then there is ex-housing. Housing is one thing. There seems to be near-term pressure on rents even outside of the big cities, as delinquencies are at last rising (as many have long predicted).
  • Measured rental inflation is lower (even if quoted rents aren’t) to the extent that landlords don’t expect to collect the full rent, so that’s a downward effect.
  • But longer-term, housing is doing just fine – home price changes, in fact, are accelerating – so I am not concerned that rental deflation will stay around very long.
  • For a discussion of housing, see my post from october 23 here:
  • So shelter will probably be soft though we’re due for a bounce in Lodging Away from Home. But outside of shelter, the “non-sticky” is what I really want to see. As I mentioned, there are supply chain problems out there and it’s affecting prices because it affects supply.
  • Used Cars might have some more upside, though the early-summer surge looked to be past when that subcomponent declined slightly last month. But the surveys of used car prices are headed back up.
  • Last month, overall core CPI was weak largely because Medical Care tanked. That was the real outlier. I’m keenly interested to see if it rebounds. It’s implausible to think that medical care prices aren’t inflating much.
  • Broadly, consensus this month is for 0.1% on core and just a smidge over 1.5% y/y. No real opinion there – as I said, I’m compartmentalizing. I want to see ex-shelter.
  • Do remember, as I constantly remind: the #Fed doesn’t care one bit about inflation. But if YOU do, and have interests in how to hedge/invest in the inflationary period approaching, visit
  • There’s a growing tide of stories about inflation, both anecdotal ones and stories of the “smart people worried” variety. And I’m seeing lots of interest in new product development in inflation space, and working on several with customers. 2021 will be busy.
  • OK, let’s see what the BLS has in store for us this month. Good luck. And in case I forget to say it later, Happy Holidays. Now let’s light this candle!!
  • Core CPI +0.22%, higher than expected. y/y at 1.647%…rounded to 1.6%, but almost ticked up to 1.7%. But remember: let’s compartmentalize. See the breakdown.
  • Just a quick glance tells me this will be interesting. Used Cars, a usual suspect when we’re above consensus, wasn’t it. -1.28% m/m, which means next month probably it adds. And rents were soft.
  • Owners’ Equivalent Rent was +0.03% m/m, dropping the y/y to 2.28% from 2.50%! That’s a huge drop. Primary Rents +0.04%, y/y foes to 2.45% from 2.67%. Also huge. All of that temporary though.
  • Lodging Away from Home did rebound as expected: +3.93% on the month. So total housing was 0.27% m/m, even though the big pieces belly-flopped.
  • And Medical Care was down again, -0.13% m/m. So what was UP??
  • Well, airfares were +3.5% m/m. Motor Vehicle Insurance rebounded 1.2% m/m after falling last month.
  • Core Goods inflation rose to 1.4% y/y. Core services was flat at 1.7%. You’re looking at supply chain and classic too-much-money-chasing-too-few-goods.
  • Core ex-shelter rose to 1.47%, reversing the deceleration from last month. Still not terribly high, but heading the wrong way.
  • Shelter, and core ex-shelter. Outside of shelter, there’s no sign that covid is causing anything that looks like deflation or even disinflation.
  • Apparel was +0.92% on the month, which is a whopper and a part of the ‘how is this happening’ story, even though it’s only 2.8% of the CPI.
  • Biggest declines on the month were jewelry and watches (-14.5% annualized) and used cars and trucks (-14.4% annualized). But there’s a long list of categories annualizing over 10%:
  • Motor Vehicle Insurance (13.8%), Footwear (17.6%), Men’s/Boys Apparel (28.5%), Misc Personal Goods (+31.9%), Public Transportation (+34.4%), Infants’/Toddlers’ Apparel (+51.3%), Lodging AFH (+58.9%), Car/Truck Rental (+66.8%).
  • So here’s the thing. Because there were small categories with BIG rises and big categories with small declines, the “average” CPI is exaggerated. Median CPI in fact should be very soft, maybe even +0.04% this month. And Median y/y should fall, pretty sharply even.
  • To be sure, if the skewness goes from being on the downside where it’s been for years, to being on the upside – that’s partly what inflation looks like. More on this later when I show distribution stuff.
  • Appliances inflation, part of that core goods component, continues to accelerate. CPI for Major Appliances is now +17.2% y/y, which you probably know if you’ve been remodeling.
  • The overall Housing subcomponent inflation rose to 2.00% y/y from 1.95%. But that’s despite big drops in primary and owners’ equivalent rent. BECAUSE of things like appliances, tools, housekeeping supplies, furniture…all up.
  • As noted, a big part of the “small categories, big changes” came from apparel subcategories. But here’s the overall apparel category. Not exactly terrifying (this is price level, not inflation). The price of clothing is back to roughly what it was in the late 1980s.
  • Totally have skipped over medical care so far. At least we saw increases in some categories although it remains…improbably soft. Medicinal Drugs -0.19% m/m. Doctors’ Services +0.13% m/m. Hospital Services +0.33% m/m. I still don’t buy it.
  • Skipping back to rents – the decline is getting to the implausible level. Again, this isn’t really quoted rents – this is being caused by rent delinquencies.
  • It’s really, really important to remember that home prices don’t follow rents, rents follow home prices (usually). With home prices shooting higher, rents will not keep decelerating. These are substitutes. Over time they move together.
  • So, this distribution is starting to look different. Tails are starting to extend to the high side while the big middle is temporarily moving left b/c of rents.
  • But having the long tail on the upside, which will cause median CPI to eventually be BELOW core instead of above it as it has been for years, is part of what inflation looks like. Kernels popping.
  • I’m going to do the four-pieces charts, then the perceived inflation index, then wrap up.
  • I see we have a number of new joiners this month so to set up the “four pieces” charts: this is just one way of slicing the data into reasonable categories so that each piece is around one quarter of CPI. Food & Energy, Core Goods, Core Services ex-Shelter, and Shelter.
  • Piece 1: Food & Energy. About 20% of CPI.
  • Piece 2, core goods, also about 20%. Talked about this earlier. This is supply chain disruption, and money chasing goods. Appliances. Furniture. But not medicines, weirdly.
  • Core services less Rent of Shelter – weak, as Medical Care Services is weirdly soft. I really don’t understand this. Some of it is auto insurance, which is soft because people aren’t driving as much, but this just seems odd.
  • Rent of Shelter, 1/3 of CPI and a plurality of core CPI. This is where you’ll see really strident arguments on both sides over the next month. But remember, it’s largely about delinquencies. If there’s another stimulus and folks get current on rent, this will reverse.
  • Perceived inflation still running about 1.1% above core inflation.
  • So to wrap up: Core surprised to the upside, because of large changes in small categories like apparel, furniture, and appliances. This means median CPI, which we pay more attention to, will be softer this month.
  • Compartmentalizing: rents continue to be soft, but I don’t think they’ll stay that way. Core goods are clearly pushing higher in a way they haven’t for years, and everyone sees this especially during the shopping season. People don’t shop for services for Christmas.
  • Core services, even ex-shelter, remain curiously weak. Softness in medical care remains a conundrum to me.
  • Bottom line is that this upside surprise isn’t as alarming as it could be, in the same way last month’s downside surprise wasn’t really helpful to deflationistas. But the kernels popping to the high side is an interesting phenomenon that is becoming more common.
  • That might be related to the COVID economy, or it might be a shift to an inflationary price dynamic from the disinflationary price dynamic we’ve seen for decades, where the middle is steady but we get occasional downside tails from price-cutting.
  • Time will tell. However, there is nothing here to make Fed governors wake up early to catch the next CPI. They don’t care about inflation, and it will be a while before it gets on their radar screens. By the end of 2021, maybe.
  • Thanks for tuning in. I will post a summary of this string of tweets at in a half hour or so. Please stop by and peruse the blog, or better yet come by and drop me a note so we can talk about how to work together. Happy holidays!

This was a really different CPI in a number of ways. For one thing, Apparel actually contributed to the upside. The number of core goods categories – small ones – showing large price increases is really unusual, and fascinating. Some of this is clearly temporary: the global supply of shipping containers is all in the wrong places, and there aren’t enough of them anyway, and this is causing sharp increases in shipping costs, delays in shipping, and therefore shortage in end product markets. This would ordinarily be merely inconvenient, but pressing against that shortage of many sorts of consumer goods is a large increase in the amount of money. When helicopters drop a few thousand dollars in everyone’s pocket and many of them run out to spend it, but the shelves are sparse – you get price increases. I am not sure this is as temporary as we want to think. In the initial helicopter drop, a lot of that money was saved at least temporarily, and money velocity fell. But that was partly because we were all shut-ins; we’re also finding out it was partly because there weren’t enough products to buy. I think we’re going to continue to see that money come gradually out of savings and into spending, and I am not sure the global supply chain can keep up yet.

We aren’t yet seeing the broad inflationary pressures. Obviously, rents are soggy but core services in general are weak. I don’t think that will persist; I wonder how much is due to the hangover from the lockdowns. But the lengthening of the upside tails is one characteristic of an inflationary process. I wrote about this recently in “Are the Inflation Kernels Starting to Pop?” and that’s worth a quick read. It has been a long time since we have seen a true inflationary process even when we’ve seen occasional accelerations in inflation itself, so we tend to forget. When inflation is rising at 4%, it doesn’t mean the price of everything we buy is going up at a uniform 4% per year. What actually happens is that prices are sticky, then they jump. This happens for a number of reasons, such a “menu costs” (the cost of reprinting menus, back when that was a thing), and the fact that you have to explain to customers why prices are changing so you do it as infrequently as possible. So what happens is that the price of a particular item goes up 0%, then 0%, then 12%. When that happens, median inflation is below core inflation, because the long upside tails pull up the average. When instead we are in a disinflationary environment, prices go up 2%, then 2%, then get a price cut of 6%. In that case, median inflation will be above core inflation, because the long downside tails pull down the average.

So even though core CPI has been below median for a generation, that isn’t guaranteed. In fact, it’s a possible indicator. Look at the following chart. For years, median CPI had been below core, during an inflationary period. In 1994-5, the positions reversed and they’ve been that way basically ever since.

Obviously, core CPI is still below median CPI. But when the Cleveland Fed reports it today, Median CPI is going to decelerate quite a bit. I don’t think Median is going to keep going down – I think it, and core, are going to go up from here and probably for quite a long time. My point though is that these long tails to the upside are interesting, and worth noting. And if Core CPI crosses above Median over the next few months and quarters, then look out.

Developed Country Demographics are Inflationary, not Deflationary

July 17, 2018 4 comments

I’m a relatively simple guy. I like simple models. I get suspicious with models that seem overly complicated. In my experience, the more components you add to a model the more likely it is that one of them ceases having explanatory power and messes up your model’s value. In this it is like (since tonight is Major League Baseball’s All-Star Game I thought I’d use a baseball analogy) bringing in relievers to a game. Every reliever you bring in has some chance that he just doesn’t have it tonight, so therefore you ought to bring in as few relievers as you can.

Baseball managers don’t seem to believe this, so they bring in as many relievers as they can. Similarly, economists don’t seem to believe the rule of parsimony. The more complexity in the model, the better (at least, for the economist’s job security).

Let’s talk about demographics and inflation.

Here’s how I think about how an aging population affects inflation:

  1. Fewer workers in the workforce implies a lower unemployment rate and higher wages, c.p.
  2. A higher retiree/active worker ratio implies lower saving, which will tend to send interest rates higher and equity prices lower, and tend to increase money velocity, c.p.
  3. A higher retiree/non-retiree ratio probably implies lower spending, c.p.

It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around #3, and the idea that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. But if there’s lower spending, that doesn’t necessarily indicate a wider output gap because of #1. The best you could say about the effect on the output gap of an aging population is that it is indeterminate: potential output growth should decline because of workforce decline (potential output growth » growth in the # of workers + growth in productivity per worker), while demand growth should also decline, leading to uncertain effects on the output gap.

I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.

The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MVºPQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.

So, my model is simple, and you don’t need to have a lot of extraneous dynamics if you simply say: slower potential growth implies higher potential inflation, and demographics implies lower potential future growth. Qed.

One other item I would point out about the three points above: all three are negative for stock markets. If you truly believe that the dominant effects are lower spending, less savings, and higher wages the you can’t possibly think that demographics are anything other than disastrous for equity valuations in the future.

Moving Goalposts

November 14, 2013 9 comments

The equity melt-up continues, with the S&P 500 now up more than 25% year-to-date in a period of stagnant growth and an environment of declining market liquidity. The catalysts for the latest leg up were the comments and testimony by Fed Chairman-nominee Janet Yellen, whose confirmation hearings began today.

Her comments should alleviate any fear that Yellen will be anything other than the most dovish Fed Chairman in decades. Ordinarily, potential central bankers take advantage of confirmation hearings to burnish their monetarist and hawkish credentials, in much the same way that Presidential candidates always seem to try and campaign as moderates. It makes sense to do so, since the credibility of a central bank has long been considered to be related to its dedication to the philosophy that low and stable prices promote the best long-term growth/inflation tradeoff. Sadly, that no longer appears to be the case, and Janet Yellen should easily be confirmed despite some very scary remarks in both the scripted and the unscripted part of her hearing.

In her prepared remarks, Yellen commented that “A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases.” Given half a chance to repeat the tried-and-true mantra (which Greenspan used repeatedly) about the Fed balancing its growth and inflation responsibilities by focusing on inflation since growth in the long run is maximized then inflation is low and stable…Yellen focused on growth as not only the primary but virtually the only objective of the FOMC. As with Bernanke, the standard which has been set will be maintained: we now use extraordinary monetary tools until we not only get a recovery, but a strong recovery. My, have the goalposts moved quite a lot since Volcker!

That means that QE may indeed last forever, since QE may be one of the reasons that the recovery is not strong (notice that no country which has employed QE so far…or ever, as far as I know…has enjoyed a strong recovery). In a very direct sense, then, Yellen has declared that the beatings will continue until morale improves. And I always thought that was just a saying!

I would call that borderline insanity, but I am no longer sure it is borderline.

Among other points, Yellen noted that the Fed is intent on avoiding deflation. In this, they are likely to be successful just as I am likely to be successful in keeping alligators from roosting on my rooftop. So far, there is no sign of it happening, hooray! I must be doing something right!

Yellen also remarked that the Fed might still consider cutting the interest it pays on banks’ excess reserves, or IOER. The effect of this would be to release, all at once, some large but unknown quantity of sterile reserves into the transactional money supply. If there was any question that she is more dovish than Bernanke, there it is. It was never clear why the Fed was pursuing such a policy – flood the market with liquidity, and then pay the banks to not lend the money – unless the point was merely to reliquify the banks. It is as if the Fed shipped sealed crates of money to banks and then paid them rent for keeping the boxes in their safes, closed. If you’re going to do QE, this is at least a less-damaging way to do it although it raises the question of what you do when you need the boxes back. Yellen, on the other hand, is open to the idea of telling the banks that the Fed won’t pay them any longer to keep those boxes unopened, and instead will ship them crowbars. This only makes sense if you really do believe that money causes growth, but has nothing to do with inflation.

The future Fed Chairman also declared that the Fed has tools to avert emergence of asset bubble. Of course, no one really doubts that they have the tools; the question is whether they know how and when to use the tools. And, to bring this to current events, the question is no longer whether they can avert the emergence of an asset bubble, but whether they can deflate the one they have already re-inflated in stocks, and an emerging one in property! Oh, wait, she’s at the Federal Reserve…which means she won’t realize these are bubbles until after the bubble pops, and then will say that no one could have known.

Now, it may be that the U.S. is merely nominating Dr. Yellen in self-defense, to keep the dollar from becoming too strong or something. Last week’s surprise rate cut from the ECB, and the interesting interview by Peter Praet of the ECB in which he opens the door for asset purchases (which interview is ably summarized and dissected by Ambrose Evans-Pritchard here), keeps the heat on the Fed to remain the most accommodative of the major central banks.

At least the ECB had a reasonable argument that there was room for them to paint the least attractive house on the block. Europe is the only one of the four major economies (I exclude China since quality data is “iffy” at best) where central-tendency measures of inflation are declining (see chart, source Enduring Investments).

globalinfAnd that is, of course, not unrelated to the fact that the ECB is the only one of the four major central banks to be presiding over low and declining money supply gowth (see chart, source Enduring Investments).

globalmsStill, the Bundesbank holdovers must be apoplectic at these developments. I wonder if it’s too late to nominate one of them to be our next Fed Chairman?

There is of course little desire in the establishment to do so. The equity market continues to spiral higher, making the parties louder and longer. It is fun while it lasts, and changing to a bartender with a more-generous pour might extend the good times slightly longer.

It is no fun being the designated driver, but the good news is that I will be the one without the pounding headache tomorrow.

[Hmmm…erratum and thanks to JC for catching it. The S&P is “only” up 25.6% YTD (my Bloomberg terminal decided that it wants to default to the return in Canadian dollars). So originally the first paragraph had “32%” rather than 25%. Corrected!]

Summary of My Post-CPI Tweets

March 15, 2013 2 comments

Here’s a summary of my post-CPI tweets:

  • #CPI +0.7%/+0.2% ex food & energy. Y/Y core back up over 2% at 2.004%. And going higher.
  • Gasoline prices +9.1%, so there you go for everyone who thought Jan’s number was low.
  • Economists had been looking for a “soft” 0.2% on core core, and got it at +0.17% rounding up to +0.2%.
  • y/y rise in Owner’s Equivalent Rent rose to 2.14%, a new post-2008 high. That’s on the way to 3% or 4% over the next 1-2 years, at least.
  • Accelerating Major groups: whoa…EVERY major group accelerated y/y. All 8 of them. I’ve never seen that.
  • Food & Bev: 1.625% from 1.558%. Housing 1.929% from 1.805%. Apparel 2.426% from 2.115%. Transp 2.361% from 0.712%.
  • Recreation 0.890% vs 0.554%. Educ/Comm 1.740% from 1.622%. Other 1.803% from 1.574%. Only close one: Medical 3.107% from 3.095%
  • #CPI didn’t surprise on the upside, but there is just nothing weak about this number. Anywhere.
  • Well, core goods I guess. +0.3% from +0.4%. But core services went to 2.6%, mainly on housing strength. If core goods ever recover…

The mainstream media and many economists will yawn at this number and miss the big picture. There is just nothing important here that is weak. In particular, every major group accelerated on a year-on-year basis. That’s amazing. It’s not unprecedented, I am sure, but I don’t remember seeing it happen before. Usually some are accelerating, some are decelerating, even when inflation overall is accelerating or decelerating.


In particular, housing continues to quietly accelerate, as we’ve been predicting. It is going significantly higher.

Core inflation is going to accelerate further, although the next several months have solid year-earlier comparisons of +0.22%, +0.22%, +0.20%, and +0.21%. But we think we’ll see core inflation nevertheless accelerate over that time frame, and then there are six easy comparisons in a row with nothing above 0.17%. By year-end, we still think we will see core of 2.6%-3.0%.

You can follow me @inflation_guy!

Categories: CPI, Tweet Summary Tags: ,

What Will the Fed Do When It’s Finally Time to Tighten?

December 18, 2012 7 comments

Housekeeping note: if you missed my comment on CPI from Friday, you can find it here.  And if you missed my Bloomberg Radio interview with Carol Massar on Monday, don’t worry! I will post it when Bloomberg makes it available on their site.


One of the busier sessions in recent memory (although still well short of 1bln shares traded on the NYSE, which was the standard not that long ago) resulted in a sharp rally in the equity market with the S&P +1.2% on the day.

The trigger for this holiday treat was the “progress” in the budget talks and what investors see as the increasing likelihood that the ‘fiscal cliff’ is averted. Be careful, however; whatever progress there was is fairly speculative, and I suspect we will see a bad news wiggle before all is resolved.

It is ironic, perhaps, that what is moving the process closer to resolution is the Republicans’ sudden refusal to be steamrolled, and to instead try and play the game rather than try to negotiate as if both parties were trying to reach a fair resolution. I refer to the fact that Speaker Boehner has begun plans to start a separate legislative track in the House of Representatives by passing a bill that would keep the Bush tax cuts in place for most Americans; the bill would not avert the spending cuts that would take effect as part of the “fiscal cliff,” but would keep the government from reaching more deeply into citizens’ pockets on January 1st. It is, therefore, just exactly what the Republicans would want in these circumstances: spending cuts without tax increases (although fewer spending cuts than they would like).

The fact that this is a good play from the standpoint of the Republicans was immediately apparent from the fact that Democrats wasted no time in accusing Boehner of not negotiating in good faith with the President, and the President himself abruptly began to try and compromise slightly from his heretofore rigid position.

Of course, the Boener plan won’t pass the Senate because it will produce exactly zero Democrat votes, and if it somehow passed by luck it would be vetoed by the President, so it has no chance to become law. However, by putting the Democrats in the position of having to vote against tax cuts, it greatly increases the chances that both parties might negotiate to something that all parties hate, and therefore passes with flying colors.

In the US system, by Constitutional writ all revenue bills have to start in the House of Representatives, so by the very nature of this process the Republicans, who dominate the House, hold the serve in this negotiation. Incredibly, this is the first time they’ve shown any desire to use that advantage to produce a bill that represents something closer to their views.

As noted above, equities reacted very well to the Republicans’ show of spine. I’d noted several weeks back that I thought the Republicans had little incentive to negotiate, since going over the fiscal cliff represents smaller government and this may be the only opportunity that party has to get smaller government in the next few years. If this move persuades the Democrats of this fact, and the President moves to address the spending problem rather than just trying to soak the rich, then the fiscal cliff may be averted. It’s really important in a negotiation, especially if a true compromise is to be reached, that your counterparty knows that you may walk away.

Personally, I think the odds are still against this happening before year-end, but some resolution fairly early in the new year is probably odds-on. However, with the debt ceiling also approaching, 2013 may well see more of these cliffhanger negotiations.

Bonds, interestingly, sold off. You would think that the prospect for a smaller deficit, even marginally, would help the Treasury market but in this case I think investors are reacting to the fact that if the fiscal cliff is averted, it lessens the chance of near-term recession and brings forward the day of reckoning for the Fed. Today, 10-year Treasury yields rose to 1.82%, which is near the highest level since early May, and 10-year real yields rose to -0.73%. Over the last five days, nominal yields have risen 16bps, and all of that has come from real yields. That is, inflation expectations have barely moved and 10-year breakevens remain at 2.50%. Ten-year inflation swaps are at 2.77%, and the important 1-year inflation, 1 year forward has risen to 2.23%.

So, whether the ‘day of reckoning’ for the Fed is near, or far…what do they do, when they’ve hit that point? And, more importantly, what does it do to the market?

Let’s assume that we are at some point in the future and either the Unemployment Rate has dipped below 6.5%, the forward PCE inflation rate has risen above 2.5%, or inflation expectations have become “unanchored.”[1] The first thing that the Fed will do is to stop unlimited QE: the statement does not imply that they will immediately start trying to get out of the hole they are in, only that they will stop digging the hole. But suppose that inflation continues to tick up – since the evidence is that inflation is a process with momentum. What does the Fed do next? This is the real question. How quickly can the Fed react to adverse inflation outcomes?

The traditional option is that the Fed raises the overnight rate. The Fed announces this move, but the important part is what happens next: the Open Market Desk (aka ‘the Desk’) conducts reverse repos to decrease the supply of reserves, or sells securities outright if it wishes to make a more-permanent adjustment. This causes the price of reserves (also known as the overnight rate) to rise, and the Desk adjusts its activity so that the overnight rate floats near the target rate.

The problem is that this won’t work right now. There are far too many reserves in circulation for the overnight interest rate to be increased by reverse repos or small securities sales. In fact, if it wasn’t for the interest being paid on excess reserves, the overnight rate would certainly be zero, and might even be negative because the supply of reserves greatly outweighs the demand for reserves. They are called “excess” reserves for a reason – the bank doesn’t need them, and will lend them overnight for pretty much any available rate.

So in order for the Fed to push the overnight rate higher, it must first soak up all of the excess reserves in the system – about $1.5 trillion at the moment – by selling bonds. Obviously, this is not something that can be done in the short-term.

But this misses the point a little bit anyway, because it isn’t the rate that matters to monetary policy but the amount of transactional money (such as M2). The Fed can set the overnight rate at 1% by simply agreeing to pay 1% as interest on excess reserves (IOER). But that won’t do anything at all to M2, because it won’t change the amount of reserves in the system and doesn’t change the money multiplier that relates the quantity of those reserves to M2.

So the short rate is dead. It isn’t going to move for a very long time, unless the FOMC decides to help the banks out by paying a higher IOER. And if they do that, it’s not going to affect inflation so it would just be a sweet present to the banks.

Okay, so perhaps the Fed can sell those long-dated securities and push long-term interest rates higher, slowing the housing market and the economy and squelching inflation, right? That’s partly right: the Fed can sell those securities, and it can push long rates higher (although the Fed has oddly claimed that if it sold those bonds, interest rates wouldn’t rise very much, which makes one wonder why they did it in the first place since presumably the opposite would also be true and buying them wouldn’t push rates down), and that would slow growth. However, it wouldn’t affect inflation, because inflation is not meaningfully affected by growth (I’ve discussed this ad nauseum in these articles; see partial arguments here, here, here, and here). But you don’t have to believe all of the evidence on that point; just play it in reverse: if driving long rates down didn’t cause a sudden jump in inflation, why would driving long rates up cause a sudden dampening in inflation?

Fama, in that article I quoted last week, had a very good point which I thought it was worth developing in more detail. The Fed has its hands off the wheel with respect to inflation…which isn’t a problem, except that they’re sitting in the back seat. The back seat of a very, very long bus.

In any event the issue isn’t when the Fed starts its tightening, but when inflation stops going up. These are not the same things. If core inflation were to start ticking higher today, at a mere 1% per year, I think it would take 6-9 months for the Fed to stop QE (core PCE is at 1.6%), probably another 3 months at a minimum before they started to tighten, and then at least 1-2 years before they could have any meaningful impact on the money supply and cause inflation to slow. Maybe I’m being pessimistic, or maybe I’m being a bit generous by assuming that after a year the FOMC would start doing something very dramatic to sop up reserves, like issuing a trillion dollars in Fed Bills, but even assuming that everything works out just about as well as it conceivably can, if inflation started heading higher in that way then you’re looking at a core CPI figure of 4-5% before it stops rising. Like I said, it’s quite a long bus, and that translates to long “tails” of inflation outcomes.

How would markets react to this? Obviously, bond rates would be much higher, but would this be good or bad for equities? The conventional wisdom holds that equities are good hedges for inflation, because over a long period of time corporate earnings should broadly keep pace with inflation. While that is true, it is also the case that earnings tend to be translated into prices at lower multiples when inflation is high (a fact that has been known for a long time; in 1979 Franco Modigliani and Richard Cohn described this as an error but there isn’t consensus on that issue) so that stocks tend to do relatively poorly when inflation is rising and better when inflation is falling from a high level. Moreover, stocks do especially poorly in the early stages of inflation when short-term inflation is surprising to the upside, as the chart below (Source: Enduring Investments) illustrates.


This chart highlights headline inflation, rather than core, but the point should be clear: nominal bonds and equities produce good real returns when inflation is surprising to the low side (even if that means that inflation is just going up slower than expected), and very poorly when inflation surprises to the high side (even when the overall level is low).

In my mind, this means that every investor needs to have some inflation protection, but especially now when the chances for an ugly inflation surprise are significant. For the record, the best asset class when inflation is surprising to the high side as measured here? Even inflation-linked bonds have produced negative real returns in such circumstances, because the real yield increase outweighs the higher inflation accruals in the short run. But commodities indices historically produced a 4% real return over that time period when inflation surprised at least 2.5% to the upside.

[1] It isn’t clear to me why you would want to wait until they were unanchored, if anchoring matters, since presumably it isn’t easy to anchor them again. After all, the whole reason the Fed wants anchored inflation expectations is because a regime change is thought to be hard – so if they are unanchored, you’ve just made it really hard to get inflation back down. In any event there’s not much evidence that “anchored” inflation expectations matter to actual inflation outcomes, but it’s just weird to me that the Fed would imply that they’d wait until expectations get loose from the anchor.

Option-Like Payoffs

It seems we have a lot of option-like payoffs looming in the next few months.

By that I mean that we have a number of events that are likely to result in either-or (binary) outcomes. Think of them as options that are going to either finish in the money or out of the money. For example, either President Obama will win re-election, or he won’t. Either the Bush tax rates will be extended, or they won’t.

Those two are truly option-like, in that they also have a fixed maturity. We will know in 33 days who the President for the next four years will be. While the Bush tax rates could always be extended retroactively to cover 2013 even if it takes until February to hammer out an agreement so that can happen, the deadline to make transactions that put income or capital gains into 2012 rather than 2013 is December 31st.

Now, what we know about options is that as you get closer to expiry and are “near the money,” your gamma increases. Gamma is a measure of how quickly the option’s delta changes – how quickly you go from feeling like a likely winner to a sure loser. An example will help. If you own $660 call options on AAPL (closing price today $666.80), and they expire in a year, then it’s probably roughly a coin flip whether those calls will end up in the money or not.[1] We would say the delta is about 0.5. If AAPL sells off to $650, then looking one year out it’s still probably pretty close to a coin flip – obviously slightly less likely, but not a bunch. Maybe 0.49 is your delta, meaning that you have something like a 1% worse chance of ending up in-the-money.

But if, on the other hand, the options are expiring at 4pm today, then your $660 call is looking pretty good when the stock is trading at $666.80 at 2pm. Your delta might be 0.95. But when, by 3pm, the stock drops to $650, your chances of winning have declined dramatically. Your delta is perhaps 0.02. Because these odds move much more dramatically, we say this option has more gamma. This is a function of both the time to maturity and the nearness of the strike to the current price.

Option traders, who try to manage their risk by delta-hedging an option, like gamma a lot if they’re long options, and dislike it immensely if they’re short options.[2] That’s because if they’re short, the hedge involves them buying into strength (aka “buy high”) and selling into weakness (aka “sell low”), and often leads to frenetic trading and on occasion, serious moves on expiry day.

Where am I going with this? An observation: as we get closer to these “option events,” if they are still not resolved one way or the other the markets will likely grow more volatile. Consider what happens to an equity investor thinking about the ‘fiscal cliff’ as year-end approaches and no deal has been struck on taxes. The investor is going to be increasingly concerned about selling stocks in which he has gains, to book those gains in 2012 in case the tax rates go up a lot. If it appears that Congress is starting to resolve some issues, then this selling pressure may relent and the markets rebound. This could go back and forth as often as the headlines change, and I will tell you that those headlines will get more frequent as the deadline draws nearer. This implies to me that market volatility will probably increase as we get closer to the election, and as we move into year-end, because of these option-like events.

There are other option-like events, although less certain in timing (Israel attacks Iran, or not. Spain asks for aid and gets it, or not. Greece defaults, or not). These will have less obvious “gamma effects,” although as long as in each case they have at least two plausible outcomes that could well happen, it will tend to contribute to volatility.

In other words, with the VIX is near the lows for the year options seem inexpensive to me.

I’m having these thoughts today because I’m watching the wild gyrations in gasoline, which was -12 cents at Wednesday’s lows (finishing -7 cents) and +14 cents today. November gas covered nearly the entire 2-month range in 2 days’ trading. More near to my heart, inflation breakevens have spiked for the last few days (+8bps today) after spending half of September retracing from a spike to touch all-time wides (see chart, source Bloomberg).

Note that this is the ten year breakeven, so it isn’t reacting here just to gasoline. And I am not aware that the outlook for growth has changed dramatically this week, nor any major money metric. What is going on? My only guess at the moment is: gamma. Small things, like a win for the Republican challenger in last night’s debate, can cause big changes in expectations, and this will become even more true as long as the race stays tight.

If we look at just that market, we could also mull the technical issues. A market that spikes to all-time highs is one thing. A market that spikes, retraces, and then rallies back to a new high would be quite another thing altogether, and might signal a new range for inflation expectations is being formed. And oh, my, would that be significant?

The equity market remains elevated, and rising inflation expectations will eventually take a toll on multiples. It always does. I don’t want to bet against equities while inflation is currently low and the Fed is trying to push the market higher, but I believe we have some volatility ahead. With implied volatilities so low on options right now, it may be worth buying puts.

[1] I am ignoring the important nuance that in this case, the forward price will be different than the spot price – it’s not important for my illustration, but you really want to compare the strike price to the forward price of AAPL, not the spot price. I make this footnote just so that readers familiar with option theory won’t think I don’t know what I’m talking about.

[2] Again, this isn’t quite true. An option trader knows that an option with a lot of gamma also has a lot of time decay, and vice versa. As a former options trader, I can tell you there is no more helpless feeling than being long gamma on expiration day and watching the market sit in a 2-tick range, knowing you’re going to lose all your time value with no delta-hedging gains, and nothing you can do about it.

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