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

June 23, 2021 2 comments

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

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

Jerome Powell, June 22, 2021

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

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

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

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

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

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

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

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

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

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Summary of My Post-CPI Tweets (June 2021)

June 10, 2021 1 comment

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

  • It’s #CPI day again! Welcome to my data walk-up. And a special welcome to all the new followers this month. I can probably plot new followers as an indicator of interest in the subject of inflation.
  • As the inflation guy, I ALWAYS look forward to this day but this is one that is going to be a lot more-widely watched than most. And for good reason.
  • Last month, core CPI shocked everyone with a +0.92% m/m reading, the highest in 40 years; the y/y core was the highest in a quarter-century. And this month, the y/y core will rise to the highest level since the early 1990s. Only question is what year in the early 1990s.
  • That’s baked in the cake; the comp from last May was -0.07% so core will rise today, by a lot. Consensus is +0.5% m/m, pushing y/y to ~3.5%. The inflation swaps market is slightly above that, more like 0.6%. And the swaps market has been right on the last couple of surprises.
  • Before we relitigate last month’s print, let’s actually look to the PRIOR month, the March figure that dropped [ed. note: meaning, “was released”, not “declined”] in April. With last month’s fireworks we forget that March’s number (+0.34% m/m on core) was also a surprise. Moreover, it was a BROADER surprise.
  • The March CPI was NOT flattered by airfares and used cars, which were the main culprits from last month. Nor by rents. It was due to large moves in small components that no one was expecting to see jump.
  • Honestly we could see last month’s jump coming (maybe not that much). March was a true surprise.
  • THAT is the story we need to be watching behind the fireworks. The Enduring Inflation Diffusion Index, meant to measure the breadth of inflation pressures, last month reached the highest level since 2012.
  • The Fed can write off Used Cars as “transitory.” But it’s less plausible that EVERYTHING is transitory.
  • (At some level, “Transitory” doesn’t really mean anything useful unless you specify the period – see my note “All Inflation is Transitory” https://inflationguy.blog/2021/05/20/all-inflation-is-transitory/ )
  • So now moving forward to April’s figure last month. Used cars and airfares were both up more than 10% m/m. Lodging Away from Home rose 7.65% m/m. And that was the reason for the massive move.
  • Spoiler alert: last month’s rise in Used Cars CPI is only a fraction of what is still coming. See chart of the Black Book index vs the CPI for Used Cars.
  • Does that mean we will get another 10% rise in Used Cars this month? It actually could be worse (although the rise in the data could also smear over several months). This is why it’s not heroic to forecast 0.5% m/m on core CPI. Can get there easily.
  • Airfares and Lodging Away from Home should also see upward pressure but there are more zigzags there. But what I really want to look at are Primary Rents (you are a renter) and Owners’ Equivalent Rent (you own your home).
  • The eviction moratorium, which by my estimate is dampening overall core CPI by around 0.9% through the medium of rents and OER, is still in place. So we DON’T have an a priori reason to look for a rental jump. Thus if we get one – it will be caused by something else.
  • That something else is that as the country has opened up, and people have been moving hither and yon, rents have been jumping (along with home prices) even more than before. And some of that might find its way into the CPI. It probably should.
  • Without housing turning higher, it’s hard to sustain big inflation figures. But rents are going to turn higher, just not clear exactly when.
  • And of course, I’ll be looking at the broader pressures down the stack to the little stuff. That’s where the high cost of containers, plastics and packaging, freight, and the shortage of labor (among many other things) is going to show up.
  • MY GUESS is that rents stay tame with just a little uptick, used cars are still strong, we see a little strength from new cars as well, and we get another above-consensus number. I can come up with scary scenarios for this print. It’s harder to come up with gentle ones.
  • Well it should be a barn-burner. Up until now, the Fed hasn’t cared. Last month got them to talk about talking about someday maybe not doing as much QE. Another month might accelerate that talking about talking. Especially if it’s more than Used Cars.
  • But the comps get “harder” for the next 3 months; Jun-Aug 2020 were +0.24%, +0.54%, and +0.35% on core CPI. So we’ll need the strength to last into the fall before the Fed gets truly nervous. And I still think the clear majority doesn’t put inflation as a serious priority.
  • It’s up to the bond vigilantes to push the Fed to being more serious about inflation. But the bond vigilantes are enjoying the “Greenspan put” equivalent in the bond world.
  • Buckle up! That’s my walk-up. Number is out in a few.
  • Surprise! It’s a surprise. 0.7% on core.
  • Actually 0.74% m/m on core, for those who still care about hundredths! Y/y is 3.80%.
  • Core highest since June 1992.
  • Lagarde comments that inflation pressures in Europe remain subdued. READ THE ROOM!
  • Used cars +7.29% m/m. OER +0.31%. Primary Rents +0.24%. Airfares +6.98%. All of those are m/m.
  • Used Cars…still could have more to go!
  • Another month of changing the scale on my charts. Here is core goods and core services. Core goods (used cars) is getting the play but don’t ignore the recovery in core services.
  • That rise in core services is with Medical Care very very soft. Pharma (which is core goods) was -0.08% m/m; Doctors’ Services -0.03%; Hospital Services +0.16%. This remains a real conundrum.
  • Apparel was +1.22% m/m. Now, apparel is only 3% of the overall CPI, but I think we’re seeing the effect of shipping costs here since most apparel is imported.
  • The small rise in rents was in line with my expectation. But we haven’t yet seen any of the real jump to come when the eviction moratorium is ended.
  • Core CPI ex-shelter was +4.94% y/y. That’s something we haven’t seen since 1991. Of course, that’s also mostly cars at this point. Need to get further down the stack to see how broad it is.
  • It probably though IS worth noting that the rise in core-ex-shelter isn’t compensating for a prior collapse. It dipped some in early COVID. But we’re way beyond that.
  • I’d also mentioned expecting to see some participation in new cars. Here is y/y. Partly this is rise in the price of a substitute, part is increased costs (from plastics and rubber to steel).
  • Rise in New Car prices is a little harder to explain away than used cars, which is spiking partly because of 2020 rental fleet shrinkage, which leaves the supply of used cars tight.
  • Car and Truck Rental: tiny category but visceral. +10% m/m. If you’re traveling this summer and haven’t rented your car yet…you may already be too late. It’s hard to find them.
  • Domestic Services +6.42% m/m NSA. Moving/storage/freight expense (from consumer’s perspective) +5.5% m/m NSA, +16.2% y/y.
  • Early look at Median CPI, which gives a better look at pressures without outliers…my estimate is +0.32% m/m. That would be the highest in two years if I’m right. Median is never going to be as volatile as core, but we don’t want to see it +0.3% m/m regularly.
  • Key point about median and core though: in a disinflationary environment core will generally be below median. In an inflationary environment, it will generally be above. So if we’re shifting environments so all the tails are higher, then the core/median switch will persist.
  • My first glance at 10y breakevens since the number finds them +4bps on the day. They’ve been under pressure recently, I suspect less because people thought this would be a soft number and more because they’re looking for higher-inflation-beta products like commodities.
  • As a brief aside, I think people underappreciate what breakevens could do if there is a movement in investor allocations. There’s nearly $2 Trillion of TIPS outstanding. But the FLOAT is nowhere near that. When they’re gone, they’re gone.
  • Let’s see: rents tame with a little uptick. Check. Cars still strong. Check. a little strength from new cars as well. Check. Another above-consensus number. Check!
  • Let’s see. Biggest losers and gainers. No category had an annualized decline more than 10%. But above 10%: Infants/Toddler’s Apparel, Motor Vehicle Parts & Equipment, Meats Poultry Fish & Eggs, Household Furnishings and Equipment, Footwear, Women’s & Girls’ Apparel, (more)
  • Fuel Oil & other Fuels, Jewelry & Watches, Public Transportation, Used Cars and Trucks, Car and Truck Rental, Leased Cars and trucks.
  • Haven’t run this chart in a few months. Shows the distribution of lower-level price changes, y/y. The big middle finger is mostly OER. But look at not just the far right tail but the group between 3% and 5%.
  • Just a couple more items here. The diffusion index and then four-pieces. The Enduring Investments Inflation Diffusion Index rose to its highest level since 2012 today. Another way to look at the broadening of price pressures.
  • We will do the four-pieces charts and then wrap up. The four-pieces charts is a simple way of looking at the drivers of inflation. Each of the pieces is very roughly 1/4 of the index (20%-35% actually). But it puts like-with-like.
  • …and they’re also in roughly volatility-order. First, Food & Energy. BTW a lot of this is food for a change. Food inflation is not pretty. But this is ‘non-core.’
  • Piece 2 is core goods. We’ve already seen this. New and Used Cars, Medicinal Drugs, e.g. Clearly this is a big driver at the moment.
  • Piece 3 is core services less rent of shelter. And there’s no comfort here. This includes medical services, which really aren’t doing anything. Household services. Car rental. Stuff like that.
  • And lastly the slowest moving piece, Rent of Shelter. This is rising, but right now it’s mostly because of lodging-away-from-home. To be fair that was a big part of the prior slide. Rents as we have already seen aren’t doing a lot. Yet.
  • If you want to be optimistic about inflationary pressures, you want to have rents stay tame. This is really hard when home prices and asking rents are shooting higher. If you want inflation to be transitory, you really need a home price collapse. I don’t see that…
  • Not to say home prices aren’t a bit frothy right now. But the conditions for them to collapse nationally, pulling rents and thus inflation down with them as in 2009-10, don’t seem to be there. But that’s the biggest/only risk I see to higher inflation through 2021-22.
  • That’s all for today. I’ll publish a compiled tweet list on my blog later this morning. You can get that blog at https://mikeashton.wordpress.com . But if you want more than talk, visit Enduring Investments at https://enduringinvestments.com and drop me a line.
  • Thanks for tuning in. Hope all of you new followers are generous with your RT and follow recommendations!

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

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

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

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How Expecting Inflation Un-anchors Manufacturers’ Pricing Strategy

June 1, 2021 4 comments

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

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

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

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

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

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

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

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

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

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

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