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Summary of My Post-CPI Tweets

August 19, 2015 2 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 with interests in this area be sure to stop by Enduring Investments. And sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com.

  • core CPI+0.13%, softer than expected. Core y/y rose from 1.77% to 1.80% due to soft year-ago comparison.
  • Next month we drop off an 0.05%, so we will almost surely get a core uptick. Surprising we haven’t yet. Waiting for breakdn.
  • Both primary rents and owners’ equiv accelerated slightly, Which means core EX HOUSING was actually slightly down m/m
  • core services rose to 2.6% (mostly on housing); core goods fell to -0.5% from -0.4% y/y. Same story overall.
  • Apparel accelerated to -1.64% from -1.85% y/y. Story for years in apparel was deflation; in 2011-12 prices rose>>
  • >>and looked like return to pre-90s rate of rise. Then it flattened off, and has been declining again.
  • Apparel could well be a dollar story now – it’s almost all made overseas, almost no domestic competition so dollar matters.
  • our proxy for core commodities is apparel + cars + med care commodities. all 3 decelerated. Cars went from +0.5% to 0.0% y/y.
  • sorry, Apparel actually ACCELERATED to -1.6% from -1.9%, but still negative.
  • airfares not really a story. -5.6% y/y vs -5.2% y/y. The NSA number dropped but it always drops in late summer. [Ed note: see chart below]
  • airfares was -8.5%, but it was -8.1% last july, -2.9% in 2013, -2.6% in 2012…no story there. didn’t affect core meaningfully.
  • Primary rents 3.56% from 3.53%. OEW 3.00% from 2.95%. Both will continue to rise.
  • Lodging away from home also rebounded to 2.9% y/y after a one-off plunge to 0.8% y/y last month. Household energy of course down.
  • Transportation accelerated (-6.6% y/y vs -6.9%) on small motor fuel recovery. btw, airline fares are only 0.7% of CPI, so 0.9% of core.
  • Med Care: goods were dn (drugs 3.2% vs 3.4%,equipment -0.9% vs 0.0%) but prof services up (2.1% vs 1.8%),hospital svcs dn (3.2% vs 3.5%)
  • Health insurance only +0.9% y/y vs 0.7%, but more expenditures out-of-pocket under the ACA so higher infl for those categories hurts.
  • Median (due out later) might only be +0.1% this month. I have it cuffed at 0.15% but I don’t seasonally-adjust the housing sub-components.
  • Last yr Median was +0.17% m/m, so best guess is it roughly holds steady at 2.3%.
  • I don’t see how the Fed embarks on a meaningful tightening in Sep, with global economy weaker than it has been in a couple yrs.
  • Median inflation and growth plenty strong enough to “normalize” rates but that’s not a new story.
  • I’ve been saying they should tighten for a few years but not sure why they would NOW if they didn’t in 2011.
  • But Fed doesn’t use common sense or monetarist models.It’s all DSGE;who knows what those models are saying?Depends how they calibrated.
  • FWIW our OER models diverge here. Our nominal model says pressures on core start to ebb in a few mo; our real model predicts more rise.
  • I like the real model as it makes mose sense…but it’s not tested in a real upswing.
  • US #Inflation mkt pricing: 2015 0.8%;2016 0.7%;then 1.6%, 1.7%, 1.8%, 1.9%, 2.0%, 2.1%, 2.2%, 2.3%, & 2025:2.2%.
  • …so inflation market doesn’t see inflation at the Fed’s target (about 2.2% on CPI vs 2.0% on PCE) until 2023.
  • The market is not CORRECT about that, but another reason the Fed can defer tightening if they want to. And they have always wanted to.

First, let’s start with the airfares chart. One of the early headlines was that airfares plunged by the most since some long-ago year, which held down core. Well, here is the chart of airfares, non-seasonally adjusted. You tell me whether this is unusual to have airfares fall in July.

airfaresNSA

Because this is part of a normal seasonal pattern, the year-on-year figure was only slightly lower, as I note above. And airfares are a tiny part of CPI, less than 1% of the core. This is not a story.

More important will be the median CPI. This is a much better measure of the central tendency of prices than headline or core, both of which (as averages) can be skewed by a few categories having outsized moves. Median inflation has been ticking higher (see chart below) but will probably go sideways this month.

medcpi

Finally, the most important chart. There are lots of ways to model housing. If you model rents as lagged versions of the FHFA Home Price Index, or Existing Home Sales median prices, then you get one model and that model suggests that rents should begin to moderate over the next 6-12 months. Not that they will decelerate markedly, but that they will stop accelerating and therefore stop being the driving force pushing core CPI higher. But if you use those models, you have to recognize that you are calibrating over a period of very slow inflation, so that you are effectively ignoring the knock-on effect of higher inflation on rents. That is, if core inflation is around 2% and rents are 3%, then if core inflation rises to 5% you wouldn’t expect rents to be at 3%. So, you need to use a model that recognizes the interrelationship between these variables. And that sort of model implies that rents will continue to climb. Both models of Owners’ Equivalent Rent are shown in the chart below. I prefer the “real” model to the “nom” model, but we don’t know the right answer yet.

twomodels

Even if OER moderates it doesn’t mean that CPI will stop rising; it just means that the story will stop being all about rents. Core goods still have a long ways to go to normalize, and that might be the next story. But for now, I am still focused on rents.

As I said, I really don’t see how the Fed can think about hiking rates in September based on the data we have seen recently. Yes, inflation is on the border of being an issue, but that has been true for a long time. In 2011, there was plenty of growth and while high rates would not have been warranted, it is hard to argue that normal rates were not called for. And yet, we got QE and more QE. This will end up being the biggest central bank error in decades, regardless of what the Fed does in September. I doubt they will hike, and if they do then it won’t be a long series of hikes. This is still a very dovish central bank, and they will get skittish very quickly if markets balk at more expensive money – which, of course, they are wont to do.

How Far from Normal are We?

August 13, 2015 8 comments

As I have mentioned, I have been hard at work on my book and am approaching completion of the raw manuscript. The title of the book is What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already, even though it’s not due out until later this year or early next year.

Yesterday, I finished up the draft of the second section, which is the “where are we now” section (there are three sections in total, and I am part-way through the “investing” section). I really enjoyed writing the following section and I think the charts are fun. So I thought I would include a snippet of Chapter 9 here for you:

——————-

If a length of steel is flexed, it is impossible to know exactly when it will fail. We can, however, figure out when that critical point is approaching, and estimate the probabilities of structural failure for a given load. These are just probabilities, and of course such an estimate depends on our knowledge of the structural properties of the piece of steel.

With economies and financial markets, the science has not yet advanced enough for us to say that we know the “structural properties” of economies and markets. And yet, we can measure the stress markets are under by measuring departures from normalcy and make observations about the degree of risk.

Didier Sornette wrote a book in 2003 called Why Stock Markets Crash: Critical Events in Complex Financial Systems.[i] It is a terrific read for anyone interested in studying these questions and exploring the developing science of critical points in financial markets. His work goes a long way towards explaining why it is so easy to identify a bubble and yet so hard to predict the timing of its demise.

So in that spirit, let us look at a few pictures that illuminate the degree of “departures from normalcy” in which economies and markets currently are. Figure 9.6 shows the nice relationship between the increase in GDP-adjusted money supply (M/Q from Figure 3.1) and the increase in the price level (P) over the nice, regular, period between 1962 and 1992. I’ve added to this plot a dot representing the latest ten year period, and (for fun) a dot representing the ten years ending in the heat of the stock market bubble in 1999. Do we appear to be out of normalcy?

Figure 9.6: Compounded money growth versus compounded inflation, 10-year periods

fig0906

Figure 9.7 shows the relationship between stocks and spot commodity prices, as represented by the S&P 500 and the Bloomberg Commodity Index. The curve is from 1991 to 2007, excluding the period around the equity bubble (1998-2002). The two dots show the current point, and the point from December 1999. Do we appear out of normalcy?

Figure 9.7: Stocks versus spot commodity prices

fig0907

Let’s try one more. Figure 9.8 shows the same commodity index, but this time against the money supply. It makes sense that spot commodity over time should move more or less in relation to the aggregate amount of money in circulation. The relative prices of two items are at least somewhat related to their relative scarcities. We will trade a lot of sand for one diamond, because there’s a lot of sand and very few diamonds. But if diamonds suddenly rained down from the sky for some reason, the price of diamonds relative to sand would plummet. We would see this as a decline in the dollar price of diamonds relative to the dollar price of sand, which would presumably be stable, but the dollar in such a case plays only the role of a “unit of account” to compare these two assets. The price of diamonds falls, in dollars, because there are lots more diamonds and no change in the amount of dollars. But if the positions were reversed, and there were lots more dollars, then the price of dollars should fall relative to the price of diamonds. In this case, dollars have been raining from the sky and yet their price relative to commodities has not fallen – that is, the nominal price of commodities has not risen, as we would have expected. Figure 9.8 shows that the price of money, relative to hard assets like physical commodities, may be in the greatest bubble it has ever been in. And since, unlike stocks and unlike real estate, everybody holds money, this may be the biggest bubble of them all.

Figure 9.8: Commodity prices versus money supply

fig0908

All three of these figures – and I could have chosen many others – show a highly-flexed economy and highly-flexed markets. A break in this steel bar is almost assured; the only question is when.

Moreover, while we hear so much today about the “coming deflationary depression,” I have to say that with the quantity of reserves in the system and the direction in which the monetary pictures are flexed, there is in my opinion as much chance of a deflationary outcome as I have of being appointed Prime Minister of Egypt.

—–

[i] Sornette, Didier, Why Stock Markets Crash: Critical Events in Complex Financial Systems, Princeton University Press, 2003.

Categories: WWWM

Little Trouble in Big China

It is obviously time for another update. I haven’t been an active poster recently, because as many of you know I am busy working on a book for the Wiley label. I am about 80% done; however, it is very time-consuming! The title of the book is (tentatively) What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already apparently, even though it’s not due out until later this year or early next year. (No pressure, huh?)

So, I have been embroiled in the writing and editing process, and not posting much. This will change soon, but China’s overnight move to (slightly) devalue the yuan is significant enough to warrant a post. There are also some other topics that need a quick mark-to-market, but I will save those for another day.

China’s move is possibly qualitatively significant, but I don’t believe it is yet quantitatively significant. A two-percent move in a currency is barely worth recording – it is almost within the daily standard deviation band of some currencies! So, when you have read about how this dramatically changes the inflationary concern of the Fed to a deflationary concern…that’s nonsense. The Swiss Franc strengthened by 20% against all currencies, in a single day, back in January. Since then, the core Swiss inflation rate has moved from +0.4% y/y to -0.6% y/y. Also note that Switzerland’s imports amount to about 50% of its GDP.

Let’s take that as a back-of-the-envelope scalar just to do a rationality check. A 20% change in exchange rate affecting about 50% of goods and services caused a 1% move in core CPI.

The U.S. imports about $40bln in goods from China per month, out of an annual GDP of $16.3 trillion. So in this case, we have a 2% move in exchange rate affecting about 2.9% of domestic goods and services. So if the effect was linear, we would expect about 1/10th * 1/17th * 1% of a move in core CPI as a result of the Chinese action. Check my math, but that would seem to be about 0.006% movement in expected core inflation as a result of China’s revaluation. Negligible, in other words.

Now, qualitatively the effect might be higher if, for example, this presages a more-significant move by China. But even assuming that the exchange rate moved ten times as much, you are still talking about rounding error on inflation. Sure, the effect might not be linear but the essential guess is that from a price perspective we don’t care.

Certain companies and industries and goods, of course, will see a much bigger effect (it would be hard to have a much smaller effect), but it shouldn’t be a big deal – even if it is part of a larger move. From the standpoint of economic growth, it may matter more…but even so, a 2% change is unlikely to matter as much as a 10% change in shipping costs, and moves like that happen all the time.

China is a big economy, and a big trading counterparty of ours. But the U.S. is still a significantly-closed economy. While China represents about 20% of all of our imports, imports as a whole only amount to 14% of US GDP. So, in summary: this is an interesting moment politically, if China is signaling a willingness to float her currency. It is not a particularly interesting day macro-economically, at least from the standpoint of the effect on prices of this move.

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