E-piphany

Below is a summary and extension of my post-CPI tweets. You can follow me @inflation_guy:

• Core CPI unchanged – which is amazing. I can’t wait to see the breakdown on this one.
• Core 0.003%, taken out one more decimal. I thought y/y had a chance of rising to 1.8%; instead it fell to 1.61%.
• Last Dec, core was 0.10%, so part of this may be faulty seasonal adjustment. It is December, after all.
• Core services +2.4%, down from 2.5%. Core goods down to -0.8%, worst since mid-2007.
• Medical Care Commodities +4.8%! Biggest increase since 1993. Oh ACA, we hardly knew ye.
• Housing weakened, which isn’t insignificant. Primary rents 3.38% from 3.48%; OER 2.61% from 2.71%.
• We still think housing is headed higher but that was part of the surprise. Apparel too, -2.0% y/y from -0.3% previous.
• The apparel move is likely related to dollar strength. Most apparel isn’t made here.
• Accelerating major groups: Food/Bev, Med Care, Rec (28.2%). Decel: Housing, Apparel, Transp, Educ/Comm, Other (71.8%)
• Decline in apparel prices may be a story. In recent yrs Apparel had been rising after many years of dis/deflation. Weakness in Asia…
• Apparel y/y decline was largest since 2003.
• Core ex-housing down to 0.69%. Much lower than crisis lows. That’s where to look if you’re worried about deflation, not the headline.
• Very interesting core goods. Our three-item proxy is Apparel (-2%), New cars (-0.1%), and Medical Care commodities (+4.8%). Figure THAT out.
• This CPI is hard to dismiss. Hsng dip is most concerning (think it’s temporary tho), but broadening of decel categories worrisome.
• Core ex-housing looking really soft. Now, some of that is probably energy sneaking thru…not a prob normally but for BIG moves – maybe.
• That being said, market is pricing in 1% core for next yr, 1.25% for 2 years, 1.37% for 3 years…so infl market has overshot. A lot.
• number of categories at least 1 std dev above deflation went from 43% to 20% in one month.
• Now here’s something to not be worried about yet: our “relative inflation angst” index reached its highest level since 2011. Still low.

This was a wild report, full of interesting items. Let’s start with Apparel. In recent years, I have watched Apparel closely because one of my theses was that the domestic benefit from exporting production to cheap-labor countries was ending. Apparel is a nice clean category that went from normal inflation dynamics when most apparel was produced domestically (prior to 1993), to disinflation/deflation over the years where virtually all production was moved offshore, to normal inflation again once the cost savings on labor had been fully realized and so no longer a source of disinflation (at which time, costs ought to begin to track wage inflation in the exporting country, adjusted for currency moves).

While it seems that the recent decline should challenge that thesis (and that was my knee-jerk reaction), I think that perhaps it isn’t quite as clear-cut as I thought. In the past I had ignored the effect of foreign exchange movements, since (a) it didn’t matter when we were mostly domestic production and (b) over the last few years currencies have been broadly stable. I think the latest decline in apparel is almost surely related to the dollar’s strength, which unfortunately means that it isn’t as pure a test of my thesis as I had hoped. In any event, apparel is one place (one of few, in the US) where dollar strength manifests clearly in core goods prices, so this is a dollar effect.

The next chart is the chart of Medical Care Commodities (mainly pharmaceuticals). Remember when we had that quaint notion that the Affordable Care Act (Obamacare) was going to permanently reduce inflation in medical care? (Actually, we didn’t all have that quaint notion – in particular, I did not – but it was certainly a view pushed very hard by the Administration). It turns out that the decline in medical care inflation was mostly due to the effects of the sequester on Medicare payments, and now prices seem to be catching up. This is an ugly chart.

Ex-medical care commodities, however, it doesn’t appear that disinflation in core commodities will be in for much of a respite unless the dollar rally is arrested.

And now for one of the scariest charts: core inflation ex-shelter is as low as it has been since the early 2000s, when the uptick in housing costs (like now) hid a close scrape with deflation. I think the causes of that deflationary scrape were similar to those of today, if in fact we are going to head that way: too much private debt. Although the higher level of public debt makes the answer more indeterminate, high private debt imparts a disinflationary tendency. The “deleveraging” was supposed to get rid of the disinflationary tendency by moving private debt onto the public balance sheet. It really didn’t happen, except for auto companies and some large financial institutions like Fannie Mae.

The important difference between now and then is that in the early 2000s we had higher rates, higher velocity (which is correlated to rates) and no excess reserves. Today, all the Fed would need to do to arrest this tendency would be to lower the interest on excess reserves to a significant penalty rate and those excess reserves would quickly enter the money supply. Interestingly, a movement the other way – to raise interest rates – will likely also cause inflation to rise as it will raise money velocity. So I am not particularly concerned we will get into deflation even ex-housing. There are lots of ways out of that pickle. I am much more worried about overreaction. Once again, the Fed might have stumbled into the right policy: doing nothing. If you can’t be good…be lucky.

One final remark on our “inflation angst” index (not shown here): the rise in the index, which manifests itself in a perception that inflation is actually higher than reported, is driven by the increasing volatility of index components (such as airfares, gasoline, and apparel) and the increased dispersion of index components (such as apparel and medical care commodities). These both have the impact of making inflation feel higher than it actually is. It is nothing to worry about at these levels of inflation, because “higher than it actually is” still feels low. But if inflation volatility continues to pick up as the level picks up (as it eventually will), then it will feel much worse for consumers than it actually is. That’s not a 2015 story, however.

Keep in mind that the market has already discounted really bad core inflation for a long time. We are very unlikely to get such a bad outcome, unless housing collapses – which it might, since prices are getting back into bubble territory, but I don’t think it’s very likely. As a consequence, even such a bearish inflation report as this one has been followed by a rally in inflation swaps and breakevens. I think this is a wonderful time to be buying inflation. It’s hard to do in the retail market, although the Proshares UINF ETF is a reasonably clean way to be long 10-year breakevens. It is $28.80, and I expect it to be at $36 within 6-9 months. [Disclosure: Neither I nor any entity or fund owned or controlled by me owns this ETF or has any current plans to buy or sell it.] [Additional Disclosure: That would be difficult it seems. While Bloomberg says it has NAV it also seems to have been liquidated. Pity if true. But RINF, a 30-year breakeven, still exists. From $30.57, I would expect $37 over a similar period.]