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Penalizing Apple Pay
Something odd happened to me several times over our Christmas holiday trip back home, and I’ve been mulling it ever since. It feels significant, albeit on a long-horizon time scale.
At least three times, restaurants added a ‘credit card surcharge’ to our check, or had a sign on the door warning customers of the same. The surcharge was small, on the order of what the credit card processors charge the restaurateur (1-2% of the bill), and was often framed that way.
Think about that for a moment. First of all, credit card fees haven’t changed meaningfully in a long time. Probably on balance they’ve risen, but it’s fractions of a percentage point. In the running of a restaurant, it is total rounding error.
Moreover, if the cost of processing credit cards had gone up, say, 1%, then it would be much better to simply raise prices 1%. Diners aren’t particularly resistant to small changes in prices, especially after 2021 broke the skin of the milk so to speak. Adding a surcharge to use a different payment method ticks the customers off, and I saw this a couple of times.
The number of patrons who are using credit cards has probably gone up a lot in recent years. I’ve noticed myself that I so rarely use cash that I sometimes forget my ATM PIN. Apple Pay and other proximity-payment methods make it so easy that carrying my whole wallet so that I can have physical cash seems silly. It has bitten me a couple of times when I wanted to tip someone, but that’s the only time it has made a difference. Almost no one takes only cash any more. We are not yet (in the US) a ‘cashless society,’ but ease of payment has pushed us pretty far in that direction. But still, that effect is simply not big enough to make much of a difference to the restaurateur – and if it was, then it would be simply solved by changing prices just a tiny bit. Your $15 entrée becomes a $15.15 entrée. No one is walking out over that.
When you see something that seems to make little sense economically, it usually means one of two things. (1) there’s some weird behavioral bias happening, or the problem is complex and confusing, so that people are making the non-optimal decision, or (2) people are behaving rationally; you just haven’t figured it out yet. The former point seems unlikely here. The problem is pretty simple, and the behavioral biases work the wrong direction – your customers get irrationally annoyed by a 1% surcharge, so all else equal you’d want to avoid that.
So I have been mulling #2, and I have a possible answer. Why would restaurateurs annoy their customers by adding a 1% surcharge to their checks, which can be easily avoided by paying cash? Obviously, it’s because they want to receive cash. Why annoy their customers over something so small that can be addressed another way? Because the actual cost to them is not as small as it appears.
When a business receives cash, or credit, there’s a small difference in the revenue received. Why does this matter to gas stations, which have applied a discount for cash for decades and not to a service business like a restaurant? Another difference between a restaurant and a gas station is that a gas station’s costs are almost entirely the cost of goods sold – gasoline – while for a restaurant the COGS is more like 25-40% of revenues. In what way does this increase the value of cash to a restaurateur?
The answer is simple – by operating part of the restaurant on a cash basis, a very significant cost can be reduced: taxes. A gas station would have a hard time pocketing cash and not declaring the revenue, because it would be quickly obvious when the tax man looked at the books. If you’re taking in less revenue than the actual cost of the gasoline, something’s fishy. But for a restaurant, that’s harder to establish especially if you pay some of the staff in cash.
The only way it makes sense to me that some restaurants would risk ticking off customers in order to push them towards cash in a very blatant way is if the cash revenue is worth much more than a 1-2% advantage over credit card revenue, and if the number of cash-paying patrons was changing meaningfully. The former has been true for a while, but as long as plenty of people still paid cash there was no reason to risk annoying customers. Only if cash as a payment form is decreasing meaningfully – and I would bet it is – would this make sense.
I’m open to other possibilities.
The reason this is interesting to me is that the driving force here is the desire to avoid metering of revenue. But the habits of the customer base aren’t the only reason this is changing. A sign at my bank warns that anyone who transacts in cash will be subject to extra questions and ID requirements. As government deficits stay wide and taxation rates rise, incidence of avoidance should be expected to go up.
Some people are aggrieved by the movement by central banks towards Central Bank Digital Currencies (CBDCs) because they fear that authorities could abuse having absolute power over the medium of exchange. That only works if it is the only medium of exchange. But the restaurant behavior suggest that moving entirely to a cashless society could also raise prices in some ways.[1] If people simply won’t pay with cash, prices will have to go up to cover the additional taxes that business owners will have to pay on the newly-recognized revenues. Incidentally, to the extent that a movement towards contactless payments (CBDC or no) moves commerce from the cash economy to the metered economy…growth will also appear artificially higher by a small amount and tax receipts will also be higher than would otherwise be expected.
Outside of restaurants, I don’t know how prevalent cash payments for services are. I know that it is a large part of home improvement and maintenance, and I know that car dealers vastly prefer cash. If it’s just 2% of the economy, then this is merely interesting. If it’s 5-10% of the economy, it’s also significant. I don’t know that in either case I can see a trade to be made, but it’s interesting.
What do you think?
[1] Hey, I have to tie this back to inflation somehow.
Rising Mortgage Origination Hints at M2 Turn
One of the successes the Federal Reserve can tout from the last couple of years (and the list of them is pretty short, to be fair) is that after the unprecedented policy actions during COVID caused never-before-seen rates of money supply expansion, subsequent policy avoided normalizing that explosion.
Year over year growth in M2 reached 26.9%. But in 2022, as the Fed started hiking rates and shrinking its balance sheet, the rate of growth slowed until M2 reached its absolute peak in July 2022 and began to slowly decline. As of today’s H6 release, year-over-year M2 has been negative for 13 months in a row.
To be sure, after a massive explosion the level of M2 has not declined all that far as the chart below shows. I also documented this fact back in November in “Where Inflation Stands in the Cycle,” which was really a good piece. You should read it.
So the success of the Fed here can be summarized by saying, ‘at least they didn’t keep blowing up the money supply.’ Since the rise in prices is clearly and closely related to the explosion in the quantity of money we have seen (anyone who still resists this obvious truism after the mountain of recent evidence is added to the prior mountain of evidence), this was a sine qua non for getting inflation back down. It isn’t sufficient, unless it’s continued for a very long time, but it’s necessary. As I illustrated in that article linked to above (which, really, you should read), there are several ways that inflation could evolve from here as the shock to the system gradually unwinds. I’ve talked before about how velocity in the policy crisis behaved as a spring or a capacitor, absorbing a lot of ‘monetary energy’ that is doomed to be released back into the system. Velocity is still rebounding (in Q4, if forecasts for Thursday’s Advance GDP report are accurate, it will rise something like 4% annualized), but if money growth remains negative then that’s really the least-painful way this can resolve. In the last chart from that prior article (have I mentioned it’s worth reading?), slack money growth with decent growth and rebounding velocity is reflected in a movement mostly to the left, with the price level not rising much. Good outcome.
However, that outcome is predicated on the notion that the money supply remains slack. If M2 starts to rise again, then the curve drifts upward and the potential set of outcomes almost certainly involve higher prices. Naturally, I’m mentioning this because of developments that make me concerned on this score.
One thing that I seriously missed in 2022 was the fact that the increase in interest rates helped bring down money supply growth. That’s not at all intuitive, because in general changing the price of a loan tends not to change the demand for a loan by very much – especially when higher inflation is making the spot real interest rate paid by the borrower lower and lower. In other words, I assert with some decent evidence that consumer and industrial loan demand is somewhat inelastic for modest changes in interest rates. Ergo, my belief was that merely raising interest rates would not necessarily cause money growth to decelerate. As it happened, I was saved from my own mistake by the fact that the Fed was also shrinking the balance sheet, which (despite the fact that reserve balances aren’t binding on banks in the current environment, so they are essentially unconstrained in lending) I thought might help money growth to decelerate. Not that I thought we’d keep getting 20% growth, but I didn’t think we would have naturally seen money growth fall below, say, 5%. Fortunately, because the Fed was also shrinking the balance sheet my forecasts were not drastically inaccurate despite being wrongly inspired, and so I forecast 5.1% median inflation for 2023 and we got 5.06%. It’s nice when the ball actually bounces your way.
As it happens, though, for the most part higher interest rates seem to have not affected loan growth very much. C&I loan growth remained strong throughout 2022 and didn’t start to level off until the Fed was just about through tightening, and consumer loans as I expected really only started to level off when the Unemployment Rate started to rise…credit cards, not at all. And that’s because, as I said, most borrowers are not borrowing because they made a NPV calculation that said borrowing makes sense; they’re borrowing because they need to and 1% or 2% or 3% doesn’t really change that calculus very much.
But you know where it did change the calculus a lot? In mortgages. And that’s because a buyer might be reluctant to pay 1% more on a mortgage, but what the buyer also needs is someone who is willing to abandon their awesome loan. As has been noted elsewhere by lots of people, home sales absolutely cratered not because people weren’t wanting to buy but because there weren’t enough people who wanted to sell. So mortgage origination volumes also dried up, as a direct consequence of higher rates. The one large market where interest rates did have a big impact, although not for the reason you’d think, was in mortgages!
You know I wouldn’t say this unless I had a neat chart to show you. Here is the Mortgage Bankers’ Association Purchase index, tracking the volume of new loans for purchasing a home (in black), set against y/y money supply growth, in blue.
Let’s tie this up with a bow:
- Higher rates didn’t affect every kind of loan, but had a big impact on turnover, and thus origination, in one very large loan market: mortgages.
- Lower mortgage origination turns out to have been uncannily correlated with money supply growth. This may or may not be causal, but it at least means that mortgage origination merits consideration as a leading indicator of money supply growth.
- As interest rates have leveled off and even declined some, the housing market is gradually adjusting. We are seeing higher home prices, and mortgage origination has been showing signs of recovering as the chart shows (mortgage origination numbers are released before sales numbers, so expect a rise in home sales coming).
- It is going to be difficult for the Fed to keep the money supply shrinking, if origination of new mortgages rises even a little bit. This doesn’t mean M2 is going to skyrocket, just that it is going to stop shrinking (in fact, it has risen each of the last two months).
- If M2 rises at even a sober 5% pace, combined with money velocity that still has some normalization left, it will be extremely difficult for the Fed to hit its inflation target on a sustainable basis for some time.
And what should you do about it, just in case? For starters, read “Inflation Sherpa.”
2024 Balance of Risks
I am a risk manager, both literally and figuratively. Literally, since whether it is with our own funds and strategies or allocations for individual investor clients, or with my trading book back when I worked on Wall Street, the hard constraints are always capital, capital, and capital and so managing risk is part of how you make sure you don’t lose that capital. But also figuratively – my natural disposition is conservative, which is why I am a bond guy (concerned with getting my original investment back at par, at the end) rather than an equity guy (filled with dreams of a 10-bagger because I’m the first guy to figure out that Blockbuster Video is going to revolutionize video rental, and not so worried about how it will vanish almost overnight to Netflix).
So when I look at the investing landscape, I’m generally not focusing very much on ‘what I think is going to happen’; rather I spend more time thinking about the range of possible things that might happen, and their relative likelihoods. In theory, all rational investors do this but the markets do not trade like it. For example, currently Crude Oil trading at $72.60 does not seem to put any weight on the possibility of a hot war in the Middle East that could abruptly spike prices to $125/bbl or more. That’s not a prediction there will be a conflict that disrupts oil production or distribution (which, since there’s already a conflict – even though it hasn’t impacted oil production and only marginally impacted distribution – doesn’t seem like the sort of tiny-risk possibility we can ignore), but merely an observation. If you think there’s even a 10% chance that oil spikes $50/bbl, it would be worth $5/bbl. “But Mike,” you say, “maybe that’s already in the price and but for that possibility oil would be $5 lower?” Well, the risk manager in me looks for confirmation that the market is at least a little nervous, and with the Oil VIX trading at its long-term average and well below the average of the post-2020 spike it strikes me as hard to characterize the energy markets as ‘nervous.’
Anyway, this is why I dislike year-end ‘outlook’ pieces and why when I forecast CPI for a year or two out I almost always focus on a range of probable outcomes rather than a point estimate.[1] Honestly we should all do this, but not enough people have studied enough statistics to understand the significance of the error bars. If you have an experimental mean, and a nice large error bar, it signifies that you can’t reject the possibility that the true mean is anywhere in the range covered by the error bar. And that’s why, when someone introduces a new rent index that supposedly is more current but by their own admission has 15 times the standard error…I ignore it.
Enough of the preliminaries. Let me get on with this. Here are my thoughts about the balance of risks for just a few important items:
Interest rates: balance of risks is clearly higher. This was even more true at the end of the year. But with 10-year rates at 4.11%, down from 5% in October, keep in mind that two ways to get lower interest rates are already priced in: the short end of the curve reflects expectations (despite Fed officials’ protestations to the contrary) of roughly 150bps of cuts in the overnight policy rate this year, and the long end reflects inflation expectations of only 2.27% inflation over the next 5 years and only 2.30% inflation over the next decade. On top of this, consider that with the trade deficit declining but the budget deficit not declining, more of the budget deficit will have to be funded from domestic saving – and the Fed is still shrinking its balance sheet, so it is pushing in the opposite direction. The balance of risks in the bond market is to higher rates.
Stock market: balance of risks is lower, with the caveat that the picture is much better if looking at the market ex-the ‘Magnificent 7’ hot stocks (Apple, Nvidia, Meta, Tesla, Amazon, Microsoft, and Google). The S&P currently has a P/E of 21.4 and is up 24% since the end of 2022. The S&P ex-Mag7 has a P/E of 18.4 and is up 11% since the end of 2022. The Magnificent 7 themselves have a P/E of 39.5 and are up 110% over the last year.
The overall market P/E looks not-too-bad, until you remember that this is only because profit margins are currently only just a bit below at least 30-year highs (and probably lots longer – this is as far back as Bloomberg has trailing-12-months margins). The balance of risks is definitely for lower margins, which means lower earnings, which means the same equity prices would represent higher P/Es. Oh, and whatever happened to those people saying that the high equity prices were due to the really low interest rates? Haven’t heard from them in a while.
Where I have clients who are long equities, they’re long equal-weight indices so as to lessen exposure to the Magnificent 7. But even if those stocks were the only ones overvalued, it’s not reasonable to think that they can come back to earth and not bring down the rest of the market. If Apple, Nvidia, Meta, and Microsoft drop 30%, the rest of the market isn’t going to go up. However, if such a thing were to happen the market outside of the Mag 7 could feasibly eventually get to looking cheap.
Credit spreads: balance of risks is wider, with the 10-year Baa credit spread near 30-year lows. Really, how low does this go? And the tails are obviously one-way.
So I’ve said the balance of risks favor higher interest rates, wider credit spreads, lower corporate margins, and lower equity prices. It’s also useful to think about where the risks are in my risk assessments. If we get lower interest rates, instead of higher, then it’s very likely due to the economy being a lot weaker than it currently is, and the Fed ends up having to ease more than 150bps in 2024. That seems unlikely to me, but if it happens then notice that probably also means that credit spreads will widen and corporate margins, earnings, and stock prices decline. So, if you’re bullish on bonds and stocks, it seems to me you’re taking a dangerously narrow path. The balance of risks to me look bearish on both sides of that, but the bullish outcome for bonds implies (I think) a bearish outcome for stocks. It’s difficult for me to see an environment with appreciably higher stocks and bonds, unless the Fed eases aggressively without any economic weakness. So that’s your implied bet.
On the other hand, being bearish both stocks and bonds doesn’t carry such a narrow path risk. Unless the Fed eases despite a solid economy, It isn’t hard to envision an environment with lower stocks and bonds. Heck, we had just such an environment a few months ago, pre-‘pivot.’ It’s not a reach.
None of the preceding is a forecast. But investing and trading are about evaluating the range of risks, and trying to take positions with asymmetric risk-adjusted payoffs. In my opinion, long-only investors should be playing short on the yield curve (and going up credit, and inflation-linked rather than nominal) and anti- cap-weighting their stock holdings.
That’s as close to an outlook piece as I am doing this year. Have fun.
[1] In the last few years, I’ve started putting a point estimate for CPI in my Quarterly Inflation Outlook, but I also report what I see as the 1 standard deviation range so I can indicate the skewness of the risks in my view.
Inflation Sherpa
Imagine if you could be a hedge fund investor, or pension or wealth management CIO, thirty-five years ago instead of in 2024. With all of the inefficiencies that persisted before they were exploited and squeezed out by high-frequency trading, automated spread trading, and even fast-moving opportunistic asset allocation models, the opportunity set for alpha was rich and persistent.
Now imagine that there is a market today where such inefficiencies still exist: a market which is poorly understood both at the security and portfolio structure levels, due to the absence of a granular understanding of the drivers of valuation. Wouldn’t you want to be allocating capital energetically to that market? There is such a market: the market for inflation-linked and inflation-adjacent instruments.
If you were going to exploit those opportunities today, you’d need someone who exists on the cutting edge frontier of understanding that market. You don’t want to assail Everest without a sherpa. To explore these opportunities in different forms including long-only, hedge fund, or a factor overlay recognizing embedded bets in a core strategy, you need an inflation sherpa.
To echo the Cents and Sensibililty podcast: you know a guy. If you’re interested, please let me know.
Inflation Guy’s CPI Summary (Dec 2023)
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I’m changing the way I do the monthly CPI analysis. Doing it live for an audience was always stressful, especially with the inevitable data issues from time to time. Of course, as an inflation investor/trader I’ll still do it live; I just don’t have an audience. The nice part about doing it live was that the monthly report had a very similar structure to it with the same charts all of the time, and that will change. But it also means that I can lead with the important stuff sometimes, like this month. So I’m going to start today’s discussion of the slightly above-consensus CPI report (+0.31% on core, vs expectations for +0.25%) by saying the quiet part out loud:
Rents aren’t collapsing. They are decelerating, and they will continue to do so, but they are not going into deflation. Everyone today seems to be acting as if this is some huge shock, but it really isn’t. The only reason to ever have thought there would be rental deflation in an environment of housing shortage was that some of the high-frequency rent indices (which are not designed to be high-quality data; they’re data derived from a business that have been packaged as if it is high-quality data) suggested declines in rents, and an influential article – I talked about it in episode 74 of the Inflation Guy podcast – popularized the notion that you could get more information from the BLS by looking at less data. But the cost side has never improved for landlords – in fact, it keeps getting worse – so it was hard to see how there would be a general decline in rents. In some parts of the country, from which people are migrating away, e.g. perhaps inner cities, rents may fall. But those people have to go somewhere. Big migration means the housing stock is now all in the wrong places, and rents go up when there’s a shortage faster than they fall when there’s a glut.
Anyway, both my costs-based rents model above and my old rents model below suggest the same destination for rents – middle of this year or just afterwards, y/y rents should get to around 2-3%. That’s a lot lower than the current run rate for rents, of +0.47% m/m for OER and +0.42% for Primary rents this month, but it’s also far above what the general expectation has been for this large part of the consumption basket. Moreover, it appears that the longer-term pressures are for that part of inflation to scoop back higher, not lower.
So, today’s rents number was a little surprising, but not that surprising. Some are attributing the miss today to ‘just rents,’ as if it’s okay for the largest part of the CPI to have a trajectory that’s confounding many forecasts, but it wasn’t just rents. Median inflation was +0.42% m/m, keeping the y/y number above 5%. And three of the last four figures have been in that zone. Median should keep decelerating too, but it is not collapsing.
Now, I’ll note that Used Car prices were weird, again. They rose +0.49% m/m, when I (and most folks) had expected a decline. They’ve been a bit squirrelly for a while, with official inflation printing higher than the private surveys fairly persistently for 6-9 months. But on the other hand, airline fares have been persistently squirrelly lower compared to jet fuel, so these two things were ‘errors’ in the opposite direction. This month, airfares also rose, by about 1% m/m – but that was right about where it should have been given the change in fuel prices and not a surprise.
Now, the diffusion stuff is looking better, and supports the idea that median inflation will continue to decelerate.
Such a deceleration has been and continues to be my forecast. I expect median inflation to settle in the high 3%s, low 4%s, and be hard to push much below that. In the near-term, meaning maybe by early H2 of this year, we could get some numbers a little below that as the rent deceleration continues. But then the hook happens. It will be hard to get inflation below 3% for very long, especially if the Fed decides to stop shrinking its balance sheet and money supply growth recovers.
So the system is normalizing after COVID (and more relevantly, after the spastic and dramatic fiscal and monetary response to COVID). But normal is no longer sub-2%. Core services ex-shelter (so-called “supercore”) abstracts both from the deceleration in housing and the sharp drop in core goods, and it is hooking higher (this is partly because Health Insurance had been artificially depressing it and that effect is waning).
Supercore is unlikely to really plunge either. Wages remain robust. The Atlanta Fed just released its Wage Growth Tracker, at 5.2% for the fourth month in a row. The spread between median wages and median inflation, which had been stable around 1% for a long while, is heading back there (see chart). So again, we’re looking at something around 4% for median inflation unless wages start to decelerate…and there’s as yet no sign of that.
The bottom line is that while this number was only a little bit surprising, it was surprising for all the wrong reasons. There is nothing in this figure that suggests the Fed can comfortably abandon a tight-money policy and think about easing soon, and I don’t expect them to do so.
