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The Dollar – Best House on a Bad Block
I’m here to draw your attention to something alarming happening in currencies at the moment. Here is a picture of the US Dollar, which has lost a huge amount of value in the past year.
Now, before certain ones of you get all excited and say that this proves Trump is ruining the dollar and forcing foreigners to vamoose out of the United States, take a look at the Euro.
I’m not going to tease you too much with this. The first chart is just the dollar in terms of ounces of gold; the second is the Euro in terms of ounces of silver. Don’t worry, longtime readers: I’m not about to go all gold-bug on you. I could have done those charts with almost any currency against a wide variety of commodities: the Bloomberg Commodity Index is up 23% since mid-August, and +12% since the end of the year. So this isn’t just a precious metals story, and it isn’t just a dollar story. It’s a fiat currency vs ‘stuff’ story.
The recent breathless coverage of the melt-up in precious metals seemed to me to miss the bigger point of what it means. It’s awesome if you’re long precious metals. But the abrupt turn vertical is – or should be – alarming. But nothing looks alarming when it’s pointed higher.
Treasury Secretary Bessent, as I write this, just came out and stated that the United States has a strong dollar policy and has not intervened (at least not yet) to push the dollar lower against the yen. That’s all very nice but I don’t worry a lot about the level of the dollar against other currencies in the medium term and here’s why.
Let’s look at the monetary pipes, which to me imply an increase in the dollar and/or a sharp increase in long-term interest rates regardless of what happens to overnight policy rates. (Many people are concerned about long-term rates because of some vague sense that we are borrowing too much or because everyone is going to sell their US bonds – to buy what with the dollars they receive, no one seems to mention – but there is a mechanical/accounting relationship could cause that outcome).
To this end, the illustration below (Source: Enduring Investments[1]) is a helpful visual guide. For this analysis we are interested in the flows of the dollar system, more than its stock. And the important flows are – or have been – pretty stable. The US has for a long time run a substantial budget deficit, which means the government needs to source dollars by borrowing them. The three sources of those dollars have historically been foreign investors, the Fed, and domestic savers. Foreign investors have extra dollars because the trade deficit means that Americans send more dollars to foreign producers than foreign consumers send to US producers, and those extra dollars are invested in the US into government bonds (spigot on the lower left) or otherwise invested in markets or direct investment (spigot on the lower right). The Fed balance sheet, over the last decade or so, has often been a supplier of dollars to the system when it has been expanding more often than not. Finally, there are domestic savers who buy Treasury bonds among other things (but consider that when they’re buying US stocks, for example, the dollars are just sloshing from one domestic saver to another – that’s why there’s no flow shown for domestic savers buying US stocks). Those three ‘suppliers of dollars’ are the top hoses filling up the barrel of dollars in the illustration below.
Those flows tend to reach stasis via automatic stabilizers. For example, if the government is draining more money (with a big budget deficit) than is being supplied elsewhere, then either interest rates rise to induce domestic savers to provide more money, or the trade deficit expands. My concern is that automatic stabilizers tend to take time to stabilize, and currently there are some big changes. See the next illustration and focus on the differences compared with the prior one.
The cessation of the expansion of the Fed’s balance sheet has been happening for a while, and the balance sheet has even been shrinking a little. But the Trump Administration’s trade policies have caused two major changes: first, the trade deficit has been shrinking sharply (see charts below, source Bloomberg; the first shows the net trade balance monthly and the second shows the recent trends of declining imports and rising exports).
Some of this may be ‘payback’ for the surge in imports at the beginning of the year by importers trying to beat the imposition of tariffs, but there seems little question now that the trade deficit really is closing substantially. At the same time, foreign companies have been tripping all over each other to start making substantial investments into the US. In the second ‘barrel of money’ chart above, note the spigot at the lower right is really gushing, and two of the hoses supplying dollars have slowed to a trickle or stopped.
If that’s a fair representation, then what are the implications? If those trends persist, then the demand for dollars is going to outweigh the supply of dollars, leading to two outcomes. One of those is that in order to induce more dollars to fund the federal deficit, interest rates will have to rise. The Fed can control the policy rate, but in order to keep long-term rates down the Committee may eventually be forced to start up their hose again – intervening to buy Treasuries in the market to prevent long rates from rising, and expanding the balance sheet. The market stabilizer here would be for interest rates to rise and induce more domestic savings; if for policy reasons the Fed doesn’t want that then they’ll have to add more money themselves, with inflationary consequences. (It’s inflationary either way, but if interest rates rise it’s only indirectly inflationary in that higher interest rates also increase money velocity).
The other implication is that the dollar would strengthen on foreign exchange markets, since if foreigners are going to invest in the US in financial markets (or with direct investment, building new plants and so forth) they will need dollars to do so and the trade deficit is no longer providing a surplus of those dollars. It’s likely also that, with fewer dollars being sent abroad, domestic stock and bond markets would struggle more than they have been. A stronger dollar would be disinflationary at the margin, helping to hold down core goods prices, but this effect is fairly small…especially in the broader context I’ve mentioned, which is that all fiat currencies right now are getting smashed versus real stuff.
These are the implications of the recent large changes in financial flows. There are potential offsets available. If the trade deficit declines and the federal budget deficit declines also, it diminishes upward pressure on interest rates since domestic savers do not have to be incentivized to provide as much of the dollars in deficit. You can infer this from the barrel illustrations as well: if the federal budget moves towards balance, it lessens the net change in the system.
And there had been some positive signs on that score. The tariff revenue has been large, and some of the spending priorities of the prior Administration have been de-emphasized. These are positive developments which could lessen the pressure on the dollar and interest rates…except that the Trump Administration has been mooting the idea of ‘tariff dividend checks,’ increased defense spending, buying Greenland, and other significant spending initiatives.
It is also possible, even probable, that the Fed or Congress could change banking liquidity regulations in such a way that banks are forced to hold more Treasuries, which would add an additional hose to the top of the barrel. However, the more assets that banks are required to hold, worsening the return on assets of traditional banks, the more banking functions will start to move to non-bank entities or into crypto, increasing the money supply while decreasing the Fed’s control of it.
The upshot of all of these changes is that – based on the flows as we see them now, which could change – I believe we are going to see a significantly steeper yield curve and a significantly stronger dollar over the next few years.
Having said all of that, let me circle back to the start of this note – while the USD is not likely to collapse against other currencies, the movement against commodities (not to mention equities) and other real assets is disturbing. The US money supply has been accelerating recently; M2 is only +4.6% in the last 12 months, but that’s near (or may even be above) the maximum rate that is sustainable without causing inflation in a country that is deglobalizing and in demographic reverse. I am not bullish on gold and silver at these levels, and am more cautious on commodities than I have been in a while. But while I am a dollar bull against other currencies, I am a bear of fiat currencies against real assets generally…and I am concerned that the recent waterfall-like behavior of fiat presages a re-acceleration of CPI-style inflation. Commodities feed broadly into prices, but so do wages and lots of other things that are measured in terms of dollars. If the problem is fiat, and not gold and silver themselves, then it’s a bullish signal for inflation.
[1] These images were generated using AI image generation tools to create an illustrative representation for explanatory purposes.
They’re Starting to Come Around on Rent Inflation
For a couple of years, I have been relentlessly defending my forward inflation forecasts against a sizeable group of people who looked at various high-frequency rent indicators and concluded that rents were going to be imminently in deflation. (For most of the last year many of those same people thought tariffs would be a large and immediate effect increasing inflation. Fortunately for them, being wrong on both counts, at least the errors offset somewhat.)
This battle began in early 2023, shortly after the publication of new indices by the Federal Reserve Bank of Cleveland, supported by a paper entitled “Disentangling Rent Index Differences: Data, Methods, and Scope” by Adams, Lowenstein, and Verbrugge. Those authors parsed the BLS rent microdata to separate out the new tenants, and created a “New Tenant Repeat Rent” (NTRR) Index that supposedly served as a leading indicator of what all rents were going to do. Naturally, NTRR had peaked early and was heading down sharply, which reinforced the observation from things like Zillow, Apartment list, etc that new rents in the aftermath of the post-eviction-moratorium catch-up were declining.[1]
The San Francisco Fed also published a piece in mid-2023, entitled “Where is Shelter Inflation Headed,” by Kmetz, Louis, and Mondragon. Don’t get me wrong, I love it when people try to create better models of inflation processes. But this was another one that made just terrible forecasts, because (as in the former case) it was put together by econometricians who didn’t understand the actual underlying process and thought they could just torture the truth out of the data. They included this wonderful (and subsequently damning, because the Internet remembers everything) chart.
Accompanying that chart was the helpful clarifying statement, in case you didn’t get the import: “Our baseline forecast suggests that year-over-year shelter inflation will continue to slow through late 2024 and may even turn negative by mid-2024.”
In case you were curious, it didn’t turn negative; in mid-2024 it was a bit above 5%.
So back then is when I had to start defending a fairly simple premise: the behavior of landlords when they offer rents to new renters does not necessarily mirror what they offer to renewing renters. In fact, I could be even more strident – landlords could not offer lower rents to everyone, even if they offered them to new renters. That’s because a landlord needs to cover his costs or he won’t be a landlord for long. And in 2023, the costs for a landlord were still rising very rapidly – labor, energy, insurance, taxes, maintenance, and so on. My model – first presented in Enduring Investments’ Quarterly Inflation Outlook in August 2023 – suggested that rents were going to decelerate, but much more slowly than others were forecasting. I had them as low as 3% by mid-2024 before flattening out, and even that turned out to be too aggressive on the disinflation side.
By now, regular readers are familiar with this model and familiar with the fact that it still is calling for Rent of Primary Residence to hang around the current 3% level for quite a while yet. Want ‘em lower? Lower landlord costs.
But this article isn’t meant (only) to pat myself on the back. I also want to recognize when someone gets it right and the great inflation analysts at Barclays recently published an article entitled “Apples and oranges in the CPI basket: Why market rent gauges mislead on shelter,” by Millar, Sriram, Giannoni, and Johanson. It is marvelous article, and you have access to Barclays Live and care about this topic you should read it. While they don’t build a cost-plus model like I did, they got to many of the core reasons why looking at new-renter indices is bound to be misleading. My favorite charts from the piece are below (I also had these in my recent CPI report).
What my model does is tell you why that had to be the case: landlords can’t just lower rents on their whole renter base if their costs are increasing. The only exception to that would be if there had been significant overbuilding such that there was a surplus of apartments over the demand from renters. In some places, especially those currently experiencing a negative immigration shock, that may be the case (although those places happen to also be the ones experiencing large increases in insurance costs, so it’s not quite that easy). But nationwide, there is not a surfeit of apartments for rent. Ergo, no rent deflation. And it’s going to stay that way for a while.
One final note here, about the recent Trump announcement that the Administration desires less institutional ownership of single family homes and apartments. I say ‘desires,’ even though that isn’t how it was phrased, since there appears to be no obvious way that the Administration can force this. They are reportedly looking into whether antitrust regulations can be used to keep institutions from accumulating very large portfolios of shelter units, but this looks like (at best) a task for the legislature, not the executive. But let’s consider quickly what the effect would be if Trump got his way in this regard.[2] Institutions which own homes and apartments don’t hold them off the market. That would be terrible carry. They rent them, just as landlords do. If you forced institutions to divest single-family homes, it would simply move supply from the rental market to the owned-home market. That would probably drive home prices a little lower, relative to the prior baseline, but increase rent growth at the margin. This doesn’t seem productive!
[1] I talked about NTRR in a July 2023 episode of my podcast: Ep.74: Inflation Folk Remedies
[2] Honestly, I don’t think he really means to do this. Some amount of what the President says – especially the impossible things – are intended for consumption by voters. I could be wrong on this. Mr. Trump does have a way of making things happen that didn’t seem possible initially, but in this case there’s probably not much he can do and anyway it wouldn’t have a big impact anyway.
Inflation Guy’s CPI Summary (December 2025)
Let’s start this month by remembering the absolute dumpster-fire that was last month’s CPI. The number for November was patently ridiculous on its face, and it took mere minutes to realize that the BLS was showing 2-month changes for what were essentially one-month changes:
“Because what it looks like is that for many series the BLS didn’t calculate a two-month change based on the current price level – it looks like, especially for housing, they assumed October’s change was zero so that the two-month change reported for this month was actually a one-month change spread over two months. For example, even with the low Owners’ Equivalent Rent print in September, the y/y figure was 3.76%, so about 0.31% per month. The BLS tells us that the two-month change in OER was +0.27%. That looks more than a little suspicious to me.”
That in fact was what had happened. The BLS has clearly spelled-out procedures for what happens when they cannot collect a price. If they can collect the price for other similar items, they impute the data for the uncollected price by ‘adjacent cell imputation.’ Happens all the time, and has happened more since there have been fewer data collectors, and that has upset a lot of people…but it’s no big deal. What happens less often is that the BLS can collect no similar price, or they don’t have a statistically-significant sample; in that case the BLS procedures call for the prior price to be carried forward and then the price gets naturally corrected the next time it can be gathered. I’ll talk more about this in a week or two, but if the item was generally rising in price that unchanged estimate for monthly price change will be a little low in the first month and a little high in the second month. If the item was generally getting cheaper, you’ll be a little high and then a little low when you catch up. But that’s better than taking a wild unscientific guess.
But normally, that happens for tiny categories. In this case, since no prices were collected, the BLS realized that its procedures called for carryforward pricing. After the data were released, they were very transparent about the fact that this caused understatement in the CPI, and that while most categories will be corrected by normal sampling in a month or two, the rent and OER samples will take about six months to correct because of the way those samples use overlapping six-month survey panels. You don’t need to worry about the fine details here, but to realize that the October number is missing, the November number is garbage, and the year/year numbers won’t be “right” for a while.
Ergo, take everything in today’s number, and all the charts, with a grain of salt.
A little side note is that the BLS was able to collect some data for November, when there was historical data available, so some of the series are complete. And some series have a dash (“-“) for November. Bloomberg simply omits October for those series. The practical consequence is that this is a massive mess for anyone who has built spreadsheets based on fairly normal assumptions about data structure! And it will be for a while. Anyway, on to today’s number.
Over the last month, inflation markets have been little changed.
They’re actually even more unchanged than that looks like, because the apparent rise in short-term inflation expectations is a quirk of the fact that every day, the window covered by a 1-year swap rolls forward one day, and as it turns out the day that it loses on the front end is a day when the NSA CPI was declining sharply thanks to the garbage report we just mentioned. So, the new 1-year swap has less of that garbage dragging the y/y rate down, and so it rises slightly. The net result is that inflation expectations at the front end are not really rising.
The expectations for the December CPI were for +0.31% on the seasonally-adjusted headline, with +0.32% on Core. These are even more guessy guesses than normal, since economists had to figure which categories might jump back and by how much. The actual CPI came in at +0.307% (SA) on headline CPI, and +0.239% on Core CPI. We will ignore the y/y rates for now. If we take those numbers at face value, it would annualize to 2.9% on Core CPI and 3.75% on headline CPI. That doesn’t seem wildly off, with the obvious caveat that annualizing a one-month change is stupid. Sorry.
Now, the Median CPI is going to be a snap-back sort of month. I think. The median category appears to me to be one of the regional OERs, so the actual number will depend on the seasonal adjustment the Cleveland Fed applies to that subindex. And I don’t know what the Cleveland Fed did for their last data point so they may be jumping off differently than I did. But any way you slice it, we’re going to be around 0.30-0.35% for median.
This is right about where the trend was prior to September. A word on September: while it is convenient to think that September was the ‘last good data point’ we had before the shutdown, remember that month had an outlier Owners’ Equivalent Rent number (0.14%, vs a series of 0.28%-0.40% that happened in the year prior to that) that we expected to rebound in the next month. We never saw the rebound. Median CPI was also affected by that, and so the last truly normal number was August. The upshot of it is that there may be some continued deceleration in median CPI, but it isn’t clear at all.
Core goods as of this month were +1.42% y/y. They look to be leveling off a bit, and it may be that the bump from tariffs (which, contrary to economic theory but in keeping with the way it really works, got bled into prices over a period of time rather than all at once) is petering out. Too early to tell, and part of this leveling out is due to soft Used Cars data in this month’s release. Core Services, mostly housing, continues to decelerate but see all of the caveats about rents.
And yes, rents went back to doing what they had been doing. Primary Rents were +0.26% m/m, and Owners’ Equivalent Rent was +0.31% m/m. So, yeah: that dip in OER in September was a mirage, and we’re still running at 3-4% in rents although the one-month BLS blip makes it appear that we’re still decelerating. I am not sure that’s really true.
Speaking of rents, Barclays put out a great piece earlier this week. It’s called “Apples and oranges in the CPI basket: Why market rent gauges mislead on shelter,” and if you have access to it you should read it. If you do not have access to it, you can just read my articles from the last few years. Seriously, though – it’s a very good piece and I’ll talk about it more in a week or so. But here are two of my favorite exhibits from their writeup.
Since 90% or so of rents are continuing rents, and all of the high-frequency rent indicators are recording new rents…can you see why there’s a problem?
That’s why a few years ago I migrated my model for rents to be based on a bottom-up estimate of what landlord costs were doing. Here is that model with the updated Primary Rents.
Normally, the Enduring Model has more lead time, but since part of it relies on PPI data that haven’t been released since September (and which is coming out tomorrow), the look forward is shorter than normal. Still, it says the same thing I’m saying above and approximately what Barclays is now saying – 3% on rents is about where it should be. It is not likely to decline sharply from here. And that means that getting CPI to 2% is going to depend on a collapse in goods prices or core services ex-rents, neither of which I see happening soon.
Although I should point out that core services ex-rents, aka Supercore, has been looking better of late.
As with everything else, we need to wait and see how this evolves once we get a few more months of decent data. I expect core services ex-rents to continue to decelerate a little, but that’s mainly because of Health Insurance (which fell -1.1% last month, and because of the way the Health Insurance estimate changes only once per year and gets smeared over 12 months this should work out to a drag of about 1bp/month on Core CPI). Outside of Health Insurance, the downward pressure on core services ex-rents is lessening.
And really, that’s the summary of the number: some of the effects from bad stuff (e.g. tariffs, which were never as big a deal as people treated them) are wearing off but some of the positive trends (e.g. the deceleration in rents) have also mostly run their course. The Enduring Investments Inflation Diffusion Index shows that there’s a bit of an upward trend in the distribution of accelerations/decelerations.
All of which points to the same thing I’ve been saying for a while, and that’s that once the spike was over we knew inflation would drop but it was likely to settle in the high 3s/low 4s (since amended to mid-to-high 3s). The tailwinds on inflation have turned into headwinds, so monetary policy overall needs to be tighter than it otherwise would be. The Fed doesn’t see it that way yet, and new additions to the Board of Governors are definitely more likely to be dovish than hawkish. Not only that, the federal government is also adding liquidity…or will be, if the President convinces Fannie Mae and Freddie Mac to buy $200bln in mortgages. A Federal Reserve which appreciated the inflation risks would be preparing to drain away that liquidity, no matter what it was going to do on interest rates. There’s no sign of that.
As a result: I think it’s reasonable to expect dovish outcomes from the Fed from here, although Chairman Powell will doubtless try to stick it in the eye of the President (and the American people get caught in the crossfire) before his term is up. That differs from the Fed of the last 30 years only in degree. They are going to be too loose, and there’s a good risk that inflation heads higher from here (not to 9%, mind you, but getting the sign right will matter).
Which Rates Are Converging?
In early 2020, global nominal interest rates converged around zero, with the US (at the 10-year maturity point) under 1% and the EU slightly negative. The monetary spigots were on, and central banks coordinated to squirt liquidity everywhere they could. Since that time, as monetary policy has diverged somewhat, nominal interest rates have diverged. Notably, Japanese rates remained lower than other developed country rates, but in general the picture spread out a bit.
What is interesting, though, is that this behavior of nominal rates obscures what is really happening ‘under the hood’ so to speak. Recall that nominal rates are (approximately) the sum of real rates – the cost of money – and compensation for expected inflation. Thanks to the CPI swaps market and/or the inflation-indexed bond market, we can break nominal rates into these two components. The evolution of those two components tells very different stories depending on the country or region. For the purposes of this article, I’m considering the US, EU, Japan, and the UK. Obviously the UK is the smallest economic unit there but they have the oldest inflation-linked bond market so they’re a crowd favorite.
In 2020, the UK had the highest implied inflation of this set, and the lowest real rates. In the UK, long-term real rates have been persistently very much lower than in the rest of the developed world, mainly because pension fund demand caused long-term linkers to be outrageously expensive.[1] On the other end of the curve, investors in Japanese inflation have persistently priced near-deflation so that in 2020 Japan had the lowest implied inflation and the highest real rates. So, even though Japan and the UK had very similar 10-year nominal rates, the composition of those real rates was wildly different. Note that in the second chart below, I am representing real rates as the spread between LIBOR/SOFR rates and the CPI swap rates, rather than looking at the inflation bond yields.[2]
Collectively, what these charts say is that inflation expectations across many disparate economies are converging, and right now that convergence looks like it’s headed to roughly where the US is at 2.5% (adjusting for differences in index composition). On the other hand, the cost of money is not noticeably converging, although real rates are gradually rising across many economies. Real interest rates are supposed to roughly reflect equilibrium economic growth, so the picture seems to be of gradually strengthening long-term equilibrium growth expectations across the US, EU, Japan, and UK, with the US having the strongest expected growth and Japan the weakest. Notably, the UK real rate has moved above the EU’s rate, which seems to make sense to me given the hot mess Europe is right now.
I don’t think this has any hot money trading implications. But I do think it’s useful to understand that while nominal rates remain different across economies, that’s becoming more and more due to differences in real rates and less and less due to differences in expected inflation rates. Of course, you can also see that the average cost of money globally is rising. Eventually, that could cause issues for other asset classes.
[1] Naturally, there are also some differences in the inflation definitions from one country to the next, and differences in what index is used for inflation swaps, which can account for some of these differences and explain why they never will, nor should, fully converge. I am abstracting from these differences; just look at the overall trend rather than try to read too much into the absolute differences, which may have good economic reasons.
[2] One reason I am doing so is that the JGBi bonds, unlike the inflation bonds in the US, UK, and Europe, do not have a deflation floor so that when inflation is very low, the real yields on those bonds naturally diverge because of the value of the embedded deflation floor. Which isn’t what we’re trying to look at. [ADDENDUM – A reader pointed out that I am very old. What I call the “new JGBis” do in fact have the deflation floor. The “new ones” have been issued since…2013. So this turns out to not be a very good reason supporting the way I’m doing this. Man, time flies.]
