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Beware the Hook
The bungee jumper doesn’t just bounce once.
Stated in a more high-falutin’ way, perturbed systems normally don’t converge straight back to equilibrium.
Obviously, the 2020-2021 COVID-triggered episode took the form of a severe shock to the system. The initial shock (to relitigate the familiar story for the thousandth time) was the panicky global shutdown initiated due to a fear of the unknown parameters of the virus. The counter-shock was the massive fiscal and monetary response to that shutdown. Almost all of the inflation-related problems we have had since then can be traced back to the fact that the initial shock lasted 6-9 months while the counter-shock lasted multiple years. “Can you give me a little push, Daddy?” says the child on the swing. “Sure,” says Dad, who then launches Junior screaming into orbit with a mighty shove.
It doesn’t matter if Daddy stops pushing; it’ll take a while for Junior’s oscillations to get back to zero. (The therapy sessions will last for years.) And so it is with the economy.[1] Positive momentum succumbs to gravity, which induces negative momentum, which succumbs to gravity again on the other side of the zero mark.
The Fed’s massive push shows up in the following chart (source: Bloomberg); highlighted in blue (left scale) is the sharp rise in M2 from 2020-2022. This surge – which indirectly financed the direct Federal stimulus payments – was meant to offset the various contractionary forces caused by forced idleness among the ‘non-essential’ workforce, such as the 140bln contraction in revolving consumer credit (in black, right scale).
So far, so good, although you can see that the M2 explosion lasted far longer than the damage to consumer credit and most other growth and liquidity metrics. The Fed adroitly (if belatedly) began to shrink its balance sheet slowly, leaning against the continued recovery in private markets. Inflation began to subside, and although it has happened more slowly than everyone would like it is going to continue a while further as rents gradually recede to a 3-4% rate of increase.
That does not, though, get the inflation rate to smoothly converge on the target even though that seems to be the forecast of a great majority of the economists out there who are employed in fancy glass and steel buildings by fancy institutions. Indeed, we are starting to see signs of a ‘hook’ higher in certain metrics that could presage a second wave of upside surprises in inflation. The system overcorrects: the latest news from Black Friday and Cyber Monday that sales were stronger than expected driven partly by increased popularity of ‘buy now pay later’ plans[2] is something that we perhaps should have expected. And so the combination of slow-but-constant balance-sheet shrinkage at the Fed and faster credit growth is helping to produce a gentle hook higher in money growth.
To be clear, I do not expect this ‘hook’ to produce a new high in the inflation rate, and any increase is probably not even to be enough to trigger further Fed tightening from here. But it should keep the Fed sternly standing off to the side, hands on hips, with a gaze which says plainly “stop playing on that swing. You have chores.”
The point is…and I guess this goes back to some extent to my observation back in July that the volatility of inflation is a tell that the oscillations still have a ways to go before dampening back to equilibrium…that this hook is evident in lots of measures. Recently, it has been pointed out that the year-ahead inflation expectations measure in the University of Michigan consumer sentiment survey has leapt higher despite declining gasoline prices (see chart), as consumers react negatively to the disconnect between politicians saying that prices are declining and their perceptions that prices are still increasing (even if inflation is declining).
And, since the Case-Shiller numbers were out today, I’d be remiss if I didn’t point out that y/y home prices are rising again in sharp contrast to where public forecasts of rents, home prices, and housing futures have been mooted.
The reason this matters is that it seems like the investing universe is all-in on the idea that not only has inflation crested, but it is heading right back down placidly to target. The bungee-jumper’s bounce is distinctly out-of-consensus, and it could scare some people if it is perceived as a new wave, rather than as a bounce. The housing market re-acceleration, in particular, could start to get some attention and some observers might think that means the Fed needs to hike interest rates further. The reality here isn’t as important as the inflection in the narrative. Beware the hook.
[1] Fortunately, I am an inflation therapist with a very reasonable hourly rate although I do not accept most insurance.
[2] AKA “I’ll gladly pay you Tuesday for a hamburger today.”
Money Velocity Update!
Now that we have our first estimate of GDP for Q3, we also have our first estimate of M2 velocity for the third quarter. Because there is an amazing amount of uninformed hypothesis out there, I figured it was worth a quick review of where we are and where we’re going, and why it matters.
Why it matters: without the rebound in velocity, the slow-but-steady decline in M2 that we have experienced since mid-2022 would be outright deflationary. The money decline and the velocity re-acceleration are part and parcel of the same event, and that is the geyser of money that was squirted into the economy during COVID. Velocity collapsed for mostly mechanical reasons: it is a plug number in MVºPQ, and since prices do not instantly adjust to the new money supply float, velocity must decline to balance the equation. Another way of looking at it is that if you add money to people’s accounts faster than they can spend it then velocity will decline. I have previously presented an analogy that in this unique circumstance money velocity behaves as if it were a spring connecting a car, speeding away suddenly, with a trailer that has some inertia. Initially the spring absorbs the potential energy, and later provides it to the trailer as it catches up. Ultimately, the spring returns to its original length, when the car has stopped accelerating and the trailer is going at the same speed.
As M2 has declined in an unprecedented way, after surging in an unprecedented way, velocity has rebounded in an unprecedented way after plunging in an unprecedented way. All of these things are connected, episodically (but we will look at the underlying, lasting dynamics in a bit). With this latest GDP update, M2 velocity rose 1.9%, the 9th largest quarterly jump since 1970. Over the last four quarters, it has risen 10.4%, the largest on record, and 16% over eight quarters, also the largest on record.
https://fred.stlouisfed.org/series/M2V
To return to the level M2 Velocity was at, at the end of 2020Q1, it needs to rise another 4.8%. For M2 to return to the level it was at, at the end of 2020Q1, it needs to fall another 23%. One of these is likely to happen; the other one is not. The net difference, after subtracting cumulative growth (8.8% since then, so far), is a permanent increase in the price level. If M2 continues to come down, the net effect is a higher level of inflation over this period but not calamitous.
Note that there is no way we get the price level back to where it was, unless M2 declines considerably farther for considerably longer, or unless money velocity inexplicably turns around and dives again. I know that some well-known bond bull portfolio managers have been calling for that, but they were wrong the whole way along so why would you listen to them now?
I’ve been pretty clear that (a) I have been surprised that the Fed was successful in decreasing the money supply, since I thought the elasticity of loan supply would be more than the elasticity of loan demand (I was wrong), (b) I think the Fed deserves credit for shrinking the balance sheet, which they have long said doesn’t matter (it matters far more than interest rates, for inflation), (c) Powell deserves credit for turning into a hawk and pushing the institution of the Federal Reserve to become hawkish after decades under Greenspan, Bernanke, and Yellen where the only question being asked was ‘do we wait for the stock market to drop 10%, or only 5%, before we flood the system with money?’ Chairman Powell deservedly will go down in history as the guy who recognized the ‘spring effect’ that kept long-term upward pressure on inflation even as so many people were chirping about supply constraints and ‘transitory inflation’ (including, to be fair, Powell himself. But whatever he said, what he did was pretty reasonable).
However, the next bit is going to be challenging.
Velocity, being the inverse of the demand for real cash balances, is primarily affected by two main forces – one of them durable and one of them ephemeral. The ephemeral effect, which is rarely super-important, is that people tend to want to hold more cash when they are uncertain. Indeed, our model for velocity actually captured accidentally some of the ‘spring effect’ because for us it showed up as extreme uncertainty. Put another way, even if the Fed hadn’t flushed tons of money into the system, velocity would have had something of a sharp decline because of the high degree of economic uncertainty. Ergo, it was crucial that they flush in at least some money because otherwise we would have had outright deflation. They didn’t get the magnitude right, but they got the sign right. Anyway, the ‘uncertainty’ effect doesn’t last forever. The measure of uncertainty I use is a news-based index of economic policy uncertainty; it has retraced about 85% of its spike although it has been persistently high since political divisiveness became the main fact of US political life back in 2009 or so.
The more durable effect on the desire to hold cash is the presence of better-yielding alternatives to cash. When interest rates are uniformly zero and the stock market is on the moon, there’s very little reason to not hold cash. But when non-cash rates are high, and stocks and other investments more reasonably priced, cash is a wasting asset that people want to ‘put to work.’ The easiest way to see that is with interest rates, which for the last couple of decades have tracked the decline in money velocity closely as both declined.
And here is the problem. If interest rates are back at 2007 levels, then naïvely we would expect velocity to be back in the vicinity of 2007 levels also. But that is massively higher than the current level. In 2007, money velocity was around 1.98 or so: about 49% higher than the current level!
Needless to say, there’s no way the money supply is contracting that much. If velocity rose even, say, 30% then we would have a serious and long-lasting inflation problem. Fortunately, because of the economic policy uncertainty and other non-interest rate effects (I did say that “naïvely” we would be looking for 1.98, right?), the eventual rise in velocity beyond the snap-back level is much less than that. It actually only adds about 6% to the snap-back level. That still means 2% more inflation than would otherwise be expected, for three years, or 3% more for two years.
Of course, interest rates could fall again and ‘fix’ that problem. But it’s hard to see that happening while the money supply continues to contract, isn’t it? And that’s where it gets difficult. If you continue to decrease the balance sheet – which you need to do – and money continues to contract, then you probably get more velocity and inflation stays higher than you expect. Or, if you drop interest rates then you don’t get velocity much over the pre-COVID level, but you also get more money growth and inflation stays higher than you expect.
All of which adds up to one reason why I continue to think that inflation will stay sticky and higher than we want it, for a while. Powell has surprised me before, though, and this would be a good time to do it again.
Asset Class Correlations Convict Central Bank Activism
A couple of months ago (Inflation Volatility Tells Us This is Probably Not Over), I argued that one characteristic of higher-inflation environments is that the volatility of inflation numbers is also high. While it does not automatically follow that high inflation volatility implies that inflation itself will remain high, it is suggestive that cries of relief for the end of the inflationary episode might possibly be premature.
Today I expected to make a similar observation about correlations, but as you’ll see my investigations took a different turn. Previously I’ve noted that when inflation rises above roughly 2.5%, stocks and bonds tend to become correlated – which messes up a key part of the value of a 60-40 portfolio. Here’s an updated version of my favorite chart, illustrating that phenomenon. Sure enough, now that inflation has been above 2.5% for 3 years, correlations between stocks and bonds have returned to what they were back when inflation last mattered to investors: the 1965-2000 period. This has happened before, and it really isn’t surprising.
But it’s more than just stocks and bonds. I recently had the opportunity to look at the three-way correlations between stocks, bonds, and commodities. It is very unusual for all three of these correlations to be positive with each other: stocks to bonds, bonds to commodities, and stocks to commodities. Generally, if you average those three correlations you get something positive but right now the rolling 12-month correlations of those three asset classes average nearly 0.8.
In fact, the recent peak in this average of the three correlations (the heavy blue line) is the highest since TIPS were first issued in 1997.
It’s actually a little strange, when you think about it: rising inflation ought to be bad for stocks, and bad for bonds…but good for commodities! But because we are looking at rolling 12-month correlations, it’s actually more about the cointegration of financial markets. Commodities can go up over time, while bonds are going down, and they can still be correlated month-wise as long as the commodities ups are bigger, and the downs smaller, than the bonds ups and downs. (See the following hypothetical example where bonds fall 61% and commodities rise 124% in a year, but they have an 0.91 monthly correlation).
So while the high correlation is not unrelated to being in an inflationary period – after all, unless stocks and bonds are positively correlated you couldn’t get the average to 0.8! – I think it’s more likely to be an indicator of how markets overall are just chips floating about on the tide of the global liquidity cycle as it flows in and out. This hypothesis is reinforced (although it remains a hypothesis!) when we back up even further and look at these correlations going back to the 1960s. To do this, we have to use the Enduring Investments synthetic TIPS return series, which I first wrote about here. When we do this, we find out that three-way correlations haven’t been nearly this high going all the way back to 1960.
The overall level of correlation has been generally rising since…approximately September 2008. Interestingly, that’s approximately when the Federal Reserve first started the waves of QE. Coincidence?
It’s even less ambiguous if you look at rolling 36-month correlations. Since the Global Financial Crisis, the correlations have almost always been higher than the highs from the prior five decades!
It isn’t like we needed more evidence that the Fed’s heavy hand has changed markets. But it is always a good reminder that there is a cost to the endless money fountain. While central bank largesse may undergird returns (at least most of the time), it does so while increasing portfolio risk by increasing asset class correlations. There is no free lunch, indeed, even when it looks like there is.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
Enough with Interest Rates Already
One of the things which alternately frustrates me and fascinates me is the mythology surrounding the idea that the central bank can address inflation by manipulating the price of money, even if it ignores the quantity of money.
I say “mythology” because there is virtually no empirical support for this notion, and the theoretical support for it depends on a model of flows in the economy that seem contrary to how the economy actually works. The idea, coarsely, is that by making money more dear the central bank will make it harder for businesses to borrow and invest, and for consumers to borrow and spend; therefore growth will slow. This seems to be a reasonable description of how the world works. But this then gets tied into inflation by appealing to the idea that lower aggregate demand should lower price pressures, leading to lower inflation. The models are very clear on this point: lower growth causes less inflation and more growth causes more inflation. The fact that this doesn’t appear to be the case in practice seems not to have lessened the fervor of policymakers for this framework. This is the frustrating part – especially since there is a viable alternative framework which seems to actually describe how the world works in practice, and that is monetarism.
The fascinating part are the incredibly short memories that policymakers enjoy when it comes to pursuing new policy using their preferred framework. Here’s the simplest of examples: from December 2008 until December 2019, the Fed Funds target rate spent 65% of the time pinned at 0.25%. The average Fed funds rate over that period was 0.69%. During that period, core inflation ranged from a low of 0.6% in 2010 to a high of 2.4%, hitting either 2.3% or 2.4% in 2012, 2016, 2017, 2018, and 2019. That 0.6% was an aberration – fully 86% of the time over that 11 years, core inflation was between 1.5% and 2.4%. Ergo, it seems reasonable to point out that ultra–low interest rates did not seem to cause higher inflation. If that is our most-recent experience, then why would the Fed now be aggressively pursuing a theory that depends on the idea that high interest rates will cause lower inflation? The most-recent evidence we have is that interest rates do not seem to affect inflation.
This isn’t just a recent phenomenon. But the nice thing about the post-GFC period is that for a good part of it, the Fed was ignoring bank reserves and the money supply and effecting policy entirely through interest rates (well, occasionally squirting some QE around, but if anything that should have increased inflation – it certainly didn’t dampen the effect of low interest rates). This became explicit in 2014 when Joseph Gagnon and Brian Sack, shortly after leaving the Fed themselves, published “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve.” In this piece, they argued that the Fed should ignore the quantity of reserves in the system, and simply change interest rates that it pays on reserves generated by its open market operations. The fundamental idea is that interest rates matter, and money does not, and the Fed dutifully has followed that framework ever since. As I just noted, though, the results of that experiment would seem to indicate that low interest rates, anyway, don’t seem to have the effect that would be predicted (and which effect is necessary if the policy is to be meaningful).
And really, this shouldn’t be a surprise because for the prior three decades, the level of the real policy rate (adjusting the nominal rate here by core CPI, not headline) has been completely unrelated to the subsequent change in core inflation.
So, to sum up: for at least 40 years, the level of real policy rates has had no discernable effect on changes in the level of inflation. And yet, current central bank dogma is that rates are the only thing that matters.
I stopped the chart in 2014 because that’s when the Gagnon/Sack experiment began, but it doesn’t really change anything to extend it to the current day. Actually, all you get is a massive acceleration and deceleration in core inflation that all happened before any interest rate changes affected growth (seeing as how we have not yet had a recession). So it’s a result-within-a-result, in fact.
Any observation about how the Fed manages the price of money rather than its quantity would not be complete without pointing out that the St. Louis Federal Reserve’s economist emeritus Daniel L Thorton, one of the last known monetarists at the Fed until his retirement, wrote a paper in 2012 entitled “Monetary Policy: Why Money Matters and Interest Rates Don’t” [emphasis in the original title]. In this well-argued, landmark, iconic, and totally ignored paper Dr. Thornton argued that the central bank should focus almost entirely on the quantity of money, and not its price. Naturally, this is concordant with my own view, plus more than a century of evidence around the world that the price level is closely tied to the quantity of money.
To be fair, the connection of changes in M2 to changes in the price level has also been weak since the mid-1990s, for reasons I’ve discussed at length elsewhere. But at least money has a history of being related to inflation, whereas interest rates do not (except as a result of inflation, rather than as a cause of them); moreover, we can rehabilitate money by separately modeling money velocity.
There does not appear to be any way to rehabilitate interest rate policy as a tool for addressing inflation. It hasn’t worked, it isn’t working, and it won’t work.
Summary of My Post-CPI Tweets (May 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but subscribers to @InflGuyPlus get the tweets in real time and a conference call wrapping it all up by about the time the stock market opens. Subscribe by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup for June (May’s figure).
- A reminder: At 8:30ET, when the data drops, I will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.
- This month I have to skip the conference call because my daughter has an awards ceremony I need to make. But later in the morning, I will post a summary of these tweets at https://inflationguy.blog and then podcast a summary at http://inflationguy.podbean.com .
- Thanks again for subscribing!
- Although both nominal and real interest rates have risen across the board since last month, breakevens have been fairly stable except at the very short end.
- That represents relative weakness in BEI, which at this level of yields should be moving about 67% as much as 10-year nominal ylds and 2x as much as real ylds. Expectations have been declining partly because of weak energy markets, but then why are short breakevens wider?
- In short, market pricing of medium-term inflation seems very confused right now.
- That’s perhaps not so surprising. In addition to energy market softness, you also can see plenty of talk about how ‘wages might not cause inflation’ and how rents are due to decline (“no, really this time!”).
- Let’s tackle these. First, rents. Ongoing argument on this one. Here’s my take: the former surge in rents was partly a catch-up from the eviction moratorium. I highlighted this divergence back when it first happened.
- Now asking rents are declining and effective rents are still rising, beginning to close this gap. But note that the BLS rents figure never did keep pace with the asking OR effective rents.
- The top lines haven’t converged yet (to be sure, these are quarterly figures) and the bottom line is behind. I know that current rent indicators had looked softer – although they’ve been recovering lately – but I don’t see a good reason to expect a LOT of softness here.
- But if you really think that housing and the rental market are going to collapse like in 2009-10, then you’re going to have a hard time buying breakevens very much higher than you were paying in 2010.
- Except wait…in 2010, 10-year breakevens averaged 2.06%. And they’re at 2.19% now. And we don’t seem to be close to any calamity remotely like we saw in 2008-2010.
- I think these days, investors avoid buying breakevens not because they don’t believe there aren’t long tails to the medium-term upside, but because they’re worried about the short-term spikes to the downside. It’s MTM fear, not value, I think.
- So, rents have been a persistent source of strength to CPI. They are ebbing, but not nearly as fast as the consensus thinks. Last month primary rents were +0.54% m/m. This doesn’t seem wildly high to me. The prior month is the outlier so far.
- The other persistent source of strength, ALSO a story I was on a long time ago, is the core-services-ex-rents or “supercore,” which is significant because that’s where wage inflation lives.
- There was an Economic Letter from the FRB San Fran a couple of weeks ago called “How Much Do Labor Costs Drive Inflation.” https://shorturl.at/fsvEN The author concludes that “labor-cost growth has a small effect on nonhousing services inflation…”
- Well, duh. Obviously, inflation causes more-rapid wage growth, not the other way around. Cost-push inflation isn’t real – if it was, every laborer would love inflation because they would be AHEAD of it. That’s clearly wrong.
- So everyone says “wow, this means that supercore doesn’t matter and the Fed might ease.” Except that nothing changes in this argument. Anyone who said core services ex-rents was important because it CAUSED inflation missed the point anyway.
- Core services ex rents matters because it causes inflation PERSISTENCE by feeding back inflation. It makes inflation sticky. It doesn’t cause it to spiral higher.
- Core services ex-rents will remain firm. That’s a good reason the Fed will not ease any time soon.
- Heading into today’s number, both mainstream economists and Kalshi’s markets are looking for core CPI to match or fall short of the lowest core CPI so far in 2023 (0.385%, in March). I am higher. More on that in a second.
- One reason I think core will be a little higher is that used car prices were roughly unchanged, but the seasonal adjustment expects a decline. So I think that will add about 3.5bps to the SA number by itself.
- Interestingly, the lag structure from Black Book to CPI-Used Cars seems to have changed from 1 month to 0 months. That’s why everyone has been off on used cars recently. No idea why this shifted. Maybe it hasn’t, just a weird recent coincidence. But I don’t think so.
- Headline CPI forecasts are pretty close between economists/market/me. I think Food isn’t going to add very much, which is why I’m below the consensus for headline even though above the consensus for core (Deutsche Bank made a similar point in a note out yesterday).
- Now, the interesting thing is that after this month and next month, the interbank market is projecting essentially zero headline inflation for the balance of the year. Ran this chart in my blog at the end of May. https://inflationguy.blog/2023/05/31/is-inflation-dead-again/
- June to December headline inflation is in the market at 0.125%. Total. That seems unlikely, even though the seasonal adjustment factors would turn that into a +1.4% which isn’t terrible. Still, it is hard to fathom that prices are just going to freeze in place NSA.
- Not today’s problem, however! One step at a time. Good luck. I’ll be up with charts and chats right after 8:30ET.
- Core +0.44%…worse than expected.
- Both stocks and bonds acting like this is good news, so we’ll have to see the breakdown…
- It might take people a minute to figure out that this was a solid miss on core. Yes, it was 0.4% versus 0.4% expectations, but it was just barely rounded down to 0.4% while the forecasts (except for mine) were rounded up.
- Still pulling down data…the BLS is working very hard to make sure people can’t get it quickly. I can see that Used Cars was +4.4% m/m, which was more than I expected. Core Services jumped to 6.8% y/y versus 6.6%. OER was steady at 0.52% m/m; Primary at 0.49%.
- Lodging was +1.80% m/m; but airfares -2.95% m/m (weak again…I just don’t see it!).
- Energy dragged about 9bps on the headline, which was in line with my forecast. Food was +0.21% NSA m/m, about same as last month, but that’s a higher SA contribution. Food at home was +0.05% SA; Food away from home (wages y’all) was +0.47% SA. m/m
- m/m CPI: 0.124% m/m Core CPI: 0.436%
- Consensus missed on core by almost 6bps. My forecast was 0.43%. Headline was soft relative to core.
- Last 12 core CPI figures
- There is absolutely nothing disinflationary about this chart recently. Haven’t even rounded down to 0.3% on core in 6 months.
- M/M, Y/Y, and prior Y/Y for 8 major subgroups
- “Other goods and services” bears some looking into. Otherwise no large surprises.
- Core Goods: 2.03% y/y Core Services: 6.57% y/y
- Core goods maintained its prior y/y level but didn’t extend the bounce despite a nice rise in apparel. Core services is coming off but…not exactly dramatically!
- Primary Rents: 8.66% y/y OER: 8.05% y/y
- Is this the top of the rollercoaster, and how steep is the drop? Yes is the first answer, but ‘not so steep’ is what I think we’ll conclude on the second. M/M annualized are running at 6% or so, and I think we’ll probably end up between 5-6%. Much better than now, but not great.
- Further: Primary Rents 0.49% M/M, 8.66% Y/Y (8.8% last) OER 0.52% M/M, 8.05% Y/Y (8.12% last) Lodging Away From Home 1.8% M/M, 3.4% Y/Y (3.3% last)
- …by the way, the reason is higher taxes, higher wages, short supply.
- Some ‘COVID’ Categories: Airfares -2.95% M/M (-2.55% Last) Lodging Away from Home 1.8% M/M (-2.96% Last) Used Cars/Trucks 4.42% M/M (4.45% Last) New Cars/Trucks -0.12% M/M (-0.22% Last)
- I thought Used would contribute but it was heavier than I thought. New cars being down is surprising. Interesting that core goods was still flat even after this contribution and the contribution from apparel.
- Here is my early and automated guess at Median CPI for this month: 0.427%
- Median category by my calculation was West Urban OER, so the usual caveats apply about my seasonal adjustment. Might be a bit higher or a bit lower than this, couple of bps either way. However you look at it…no continued disinflation.
- Piece 1: Food & Energy: -0.939% y/y
- Piece 2: Core Commodities: 2.03% y/y
- Piece 3: Core Services less Rent of Shelter: 4.38% y/y
- “Supercore” was a little lower, but still at 4.4% y/y.
- Piece 4: Rent of Shelter: 8.12% y/y
- Probably the best news overall is that core ex-housing is down to 3.45% y/y.
- Before I get to ‘other’, let’s look at Medical Care. 0.08% m/m. Pharma was +0.51%, and 3.99% y/y. Doctors’ Services was a drag at -0.50% m/m and -0.09% y/y. Medical Equipment and Supplies was +2.3% m/m (NSA), which is the reason this is positive. Health insurance the usual drag.
- Keep in mind that when Health Insurance gets readjusted next year, Medical Care is going to turn on a dime and be a following wind pushing inflation up, not down. The Health Insurance curiosity is a major source of the apparent core inflation disinflation this year.
- Other Goods and Services was +0.53% NSA M/M. And it was pretty broad. Cigarettes +0.6%, other tobacco products 0.44%, Personal care products +1%, Misc Personal Services +0.69%.
- This is interesting. Really bipolar inflation distribution. Nothing in the middle. A lot of weight to the right, and then a big slug of things to the left. That’s why core is so much lower than median.
- Only non-core things that declined more than 10% annualized in May were Car and Truck Rental (-33%) and Misc Personal Goods (-11.9%). Neither more than 0.15% of the consumption basket.
- OVER 10% are Used Cars/Trucks (+68%), Motor Vehicle Insurance (+26%), Lodging Away from Home (+24%), and Personal Care Products (+12.8%).
- Sort of reinforcing the distribution picture. The weight in “over 6% y/y” is declining but still heavy. Weight in <2% is about 25%, rising but still low.
- Finally the EI Inflation Diffusion Index telling the same story. Upward pressures remain but are lessening. This reinforces the ‘inflation has peaked’ story but does not yet support the ‘inflation will crash to exactly 2%’ story.
- Wrapping up: bonds like this because there is no reason in here for the Fed to reverse its promise of a pause, when they meet tomorrow. The Fed will stand pat. Stocks like this mainly because it removes that uncertainty.
- There is nothing in here that supports the notion that the Fed will soon be able to stop worrying about inflation. M/M core inflation continues to run at a 5% ish level. Y/Y core will likely ease a little further on base effects through September and then level off.
- My point forecast for 2023 Median Inflation has been around 5% since last May. It is starting to look like that might be slightly low but pretty decent I think.
- Sort of the best-case for core CPI at year-end will be 4.25% y/y. Unless rents and wages suddenly (and inexplicably) drop, it’s going to be really hard to get it below that.
- On the other hand, tightening further when inflation measures are gently declining will also be a hard argument. In short, I think the “Fed on hold for a long time” argument won the scorecard handily today.
- We not only need lower inflation prints, but the distribution needs to get more uniform. Wages rising at 6% (Cleveland Fed WGT) is holding up services even as core commodities stop declining. Meeting in the middle still looks like 3-4%. Again, hard to ease, hard to tighten.
- I think that’s about it for today. I’ll have a few more words in my blog and podcast summaries, but that’s the meat of it. I still think breakevens are too low for this environment!! Thanks for tuning in.
The chart of the day is the one of month/month core CPI figures. Here is another look at it, from Bloomberg. Tell me if you can spot the downtrend.
Nope, me neither. December’s was 0.40%, and the five core prints for this year were 0.41, 0.45, 0.38, 0.41, and 0.44. The six-month average is 0.42%. The 12-month average is 0.43%. The 24-month average is 0.46%. So, if there’s a downtrend, it’s a really gentle downtrend. Base effects from last year will cause the y/y number to glide down a little bit further, and base effects in headline inflation may cause that number to decline as well although that’s a lot less clear. We’re tracking towards something like 4-5% inflation. I’m a trifle more optimistic than that, thinking we will eventually settle in the 3-4% range, but my operating hypothesis for a while has been that we have entered a new distribution with a higher mean. I could still be wrong on that, of course, but so far there’s nothing to suggest that inflation is going back to 2%.
Unless, of course, you think rents are about to flop. There has been some recent research on that, and as a result there is near-unanimity of the view that rents are going to be flat to declining “soon.” I’ve read the research, and it’s not convincing. Error bars for the forecast period are very wide right up until we get actual data, and the period over which the relationship is purported to exist is not similar to the period we are in.
Remember, people also thought that home prices would collapse under the weight of higher interest rates. They dropped a couple of percent, and are rising again already. Not only that, but mortgage delinquencies just dropped to the lowest level in 20 years: not what you’d expect if higher rates are crushing homeowners. What higher rates are doing is hurting builders, who will build less as a result, and landlords, who will raise rents as a result. The fact that economists want monetary policy and inflation to work this way isn’t sufficient. It just doesn’t.
This is not to say that there aren’t some good trends in the data. Our diffusion index clearly signals that the pressures towards higher prices are slackening. Some products and services that had seen extreme spikes are retracing. But wage growth is still 6%, and there are still a lot of goods and services which haven’t yet fully adjusted to the new price level. So: there will continue to be volatility in prices for a while, with some good news and some bad news and a gentle trend towards less inflation.
Sounds like “Fed on hold” to me.
Is Inflation Dead…Again?
I am not the first person to point out that the stock market, at outlandish multiples, is not behaving consistently with commodities markets that are flashing imminent depression. If we insist on anthropomorphizing the markets, it really makes no sense at all unless we posit that “the market” suffers from a split personality disorder of some kind. But that sort of thing happens all the time, in little ways.
But here is something that seems very weird to me. Prices of short-dated inflation swaps in the interbank market suggest that NSA headline inflation is going to rise less than 0.9% for the entire balance of 2023 (a 1.45% annualized rate). And actually, most of that rise will be in the next 2 months. The market is pricing that between June’s CPI print and December’s CPI print the overall price level will rise 0.23%…less than ½% annualized!
Now, eagle-eyed readers will notice that there was also a flat portion of 2022, covering roughly the same period. Headline inflation between June and December last year rose only 0.16%, leading to disappointing coupons on iBonds and producing proclamations that inflation was nearly beaten. Here’s the thing, though. The second half of 2022 it made perfect sense that headline inflation was mostly unchanged. Oil prices dropped from $120/bbl the first week of June, to $75 by mid-December. Nationwide, average unleaded gasoline prices dropped from $5 to $3.25 during that time period.
A comparable percentage decline would mean that gasoline would need to drop to $2.32 from the current $3.58 average price at the pump. To be sure, the gasoline futures market is in much steeper backwardation than normal, with about 44c in the curve from now until December compared with 28c from June to December 2024.[1] So that can’t be the whole source of this insouciance about inflation. If gasoline does decline that much, the inflation curve will be right…but there’s an easier way to trade that, and that’s to sell Nov or Dec RBOB gasoline futures.
So the flatness must be coming from elsewhere. It can’t be from piped gas, which has recently been a measurable lag, because Natural Gas prices have already crashed back to levels somewhat below the norm of the last 10 years. Prices of foodstuffs could fall back more, which would help food-at-home if it happened, but food-away-from-home tracks wages so it’s hard to get this huge of an effect from food.
Ergo…this really must be core. Except there, the only market where you can sort of trade core inflation rather than backing into it, the Kalshi exchange, has the current prices of m/m core at 0.35% in May, 0.32% in June, 0.57% in July, 0.45% in August, 0.35% in September, 0.18% in October, and 0.22% in November. (To be sure, those markets especially for later months are still fairly illiquid but getting better). That’s not drastically different from the 0.41% average over the last six months.
Markets, of course, trade where risk clears and not necessarily where “the market thinks” the price should be. I find it hard to understand though who it is who would have such an exposure to lower short-term prices that they would need to aggressively sell short-term inflation…unless it is large institutional owners of TIPS who are making a tactical view that near-term prints would be bad. Sure seems like a big punt, if so.
Naturally, it’s possible that inflation will suddenly flatline from here. I just don’t feel like that’s the ‘fair bet’. That is after all a key function of markets: offer attractive bets to people who don’t have a natural bias in the market in question, to offset the flows of those people who are willing to pay to reduce their risk in a particular direction. (This should not be taken to suggest that I don’t have a natural bias in the market; I do.)
There’s another reason that this matters right now. Recently, markets have also been starting to price the possibility that the Federal Reserve could continue to hike interest rates, despite fairly clear signals from the Chairman after the last meeting that a ‘pause’ was in the offing. That certainly makes sense to me, since 25bps or 50bps makes almost no difference and after one of the most-aggressive hiking cycles in history, putting rates at approximately long-term neutral at the short end, it would seem to be prudent to at least look around. If, in looking around, the Fed were to notice that the balance of the market is suggesting that inflation has a chance of going instantly and completely inert, it would seem to be even stranger to think that the FOMC is about to fire up the rate-hike machine again for another few hikes.
[1] N.b. – June to December on the futures curve isn’t the exact right comparison since prices at the pump lag wholesale futures prices, but it gives you an idea.
Food Inflation Served Hot and Cold
Well, the Fed is done raising interest rates. They aren’t quite done tightening yet, because the Federal Reserve is going to continue to shrink its balance sheet slowly. That’s important. The fact that the Fed is no longer hiking rates, but is continuing to normalize its balance sheet, is quietly impressive to me. It makes me wonder whether someone at the Fed understands that saturating the economy with bank reserves means that today’s tightening is fundamentally different from the tightening of yesteryear, which was a money phenomenon and not a rates phenomenon.
We may never know, but I do have to admit that Chairman Powell impressed me a little in his post-FOMC presser. Not impressed me like ‘he’s the greatest’ but impressed me like ‘this is what I’d hoped we were getting.’ I wrote back in 2017 that the fact he is not an economics PhD was a positive…although the fact that he did not know anything about macroeconomics before joining the Fed suggested that he has learned economics in an echo chamber from some of the most blinkered non-monetarists on the planet, whose main claim to fame is that their forecasts have been consistently, and sometimes colossally, wrong for a long period of time. Still, he has a different background and that always offers hope.
The conduct of monetary policy under Powell has certainly been different than it was under his predecessors. We have to give him that! In any event, he said several things that impressed me because they surprised me. I’ll have more details and specifics in our Quarterly Inflation Outlook released a few days after CPI this month (you can subscribe at https://inflationguy.blog/shop/ ).
But today, I’m here to talk about food inflation. Normally, food inflation along with energy is deducted from the CPI to produce Core CPI, which is more stable and therefore should give better signals with less noise as long as food and energy inflation are mostly mean-reverting. And normally, they are. Energy is famously mean-reverting; the nationwide average price of a gallon of gasoline right now is $3.574, which is down 5 cents from…April 2008. There is a lot of noise and not much signal, so it makes sense to deduct.
Similarly, food inflation has a large commodity component and is also very volatile. It is not as volatile as is energy, partly because we don’t consume most of the foods that we buy in pure commodity form but rather in a packaged form; also foodstuffs are much more heterogeneous than gasoline and so branding matters a lot. Still, the food component of CPI is pretty volatile and normally fairly mean reverting although unlike energy it definitely has an upward tilt over time.
For some time now, though, food prices have been consistently adding to overall inflation. In mid-2021, trailing 12-month CPI for the “Food” subindex was about 2%; by late 2022 that was up to 11%! Recently, though, Food has started to come back to earth a little bit. The reason why is interesting and illuminating.
“Food,” which is 13.5% of the CPI, has two primary subgroups. “Food at home” is 8.7% of the CPI (about 2/3 of “Food”) and “Food away from home” is 4.8% of the CPI. The recent deceleration in the Food category has come entirely from “Food at home” (see chart, source BLS). That group got to about 14% y/y inflation, but most recently has fallen to a mere 8%. The steadier “Food away from home” is still plugging away, last at 8.8% y/y…a new high, actually.
As you might expect, while “Food at home” does not directly track, say, wholesale cattle or wheat prices, persistent changes in commodities prices does eventually percolate into pricing. The following chart shows a very simple relationship between “Food at home” and the Bloomberg Commodity Index “Agriculture” subindex (which tracks the performance of coffee, corn, wheat, beans, bean oil, cattle, hogs, cotton, and sugar. Aside from cotton, that list comprises a good part of what Americans buy to eat at home. So it isn’t terribly surprising that, at least for large movements in prices, these things eventually show up in the prices of things we buy. In this chart, the commodity index is lagged 12 months and shown on the right-hand scale. As an aside, consider how little of the price of what we buy must represent the actual commodity cost, if a 60% rise in commodities prices only results in a 14% increase in the price of Food at home, a full year later!
That chart says that “Food at home” should continue to decelerate and be a gentle drag for another year. On the other hand, “Food away from home” has completely different drivers that aren’t related to commodities prices hardly at all.
In contrast to the prior observation, consider how much of “Food away from home” must be labor, if the correlation between labor inflation and “Food away from home” is so high and of such a similar scale. Of course, we know that to be the case: the labor shortage hit the restaurant industry very hard and those effects are still being felt. There is not yet any sign of a decline in wage growth among these workers, and consequently there is not any sign of a deceleration in inflation of “Food away from home.” It should continue to be additive to CPI for a while.
The dichotomy between these two parts of the “Food” category is, of course, exactly what concerns the Federal Reserve and other economists who examine inflation. I’ve written about it here (and spoken about it on my podcast) a bunch of times: core services ex housing is where the wage-price feedback loop lives. It’s where the persistence of inflation comes from, and that is why it is the Fed’s main focus. Although I was writing about this before the Fed ever mentioned it, I have to give them credit – I thought they would seize on the fact that energy prices are pulling down overall inflation, or that rents may be decelerating soon, and use that as an excuse to take their usual dovish turn. They have not. The Fed actually seems to be focused on the right thing.
Maybe Powell is different, after all.
Who’s Afraid of De-Dollarization?
Do we need to worry about the end of dollar dominance in international trade – the de-dollarization of global finance?
I am hoping to do a podcast on this topic in a few weeks, featuring a guest who is actually an expert on foreign exchange and who can push back on my thought processes (or, less likely, echo them) – but the topic seems timely now. There is widespread discussion and concern in some quarters, as China and Russia push forward efforts to establish the Chinese Yuan as an alternative currency for international trade settlement, that this could spell the sunset of the dollar’s dominance. Some of the more animated commentators declare that de-dollarization will dramatically and immediately eviscerate the standard of living in the United States and condemn the nation to be an also-ran third-rate economy as its citizens descend into unspeakable squalor.
Obviously, such ghoulish prognostications are ridiculously overdone for the purpose of generating clicks. But how much of it is true, at least on some level? What would happen if, tomorrow, the US dollar lost its status as the world’s primary reserve currency?
One thing that wouldn’t change at all is the quantity of dollars in circulation. That’s a number that the Federal Reserve exerts some control over (they used to have almost total control, when banks were reserve-constrained; now that banks have far more reserves than they need, they can lend as much as they like, creating as many floating dollars as they like, constrained only by their balance sheet). The holders of dollars have absolutely no control over the amount of them in circulation! If Party A doesn’t like owning dollars, they can sell their dollars – but they have to sell it to some Party B, who then holds the dollars.
What also wouldn’t change immediately is how many dollar reserves every country holds. From time to time, people get concerned that “China is going to sell all of its dollars.” But China got those dollars because they sell us more stuff than we sell them, which causes them to accumulate dollars over time. How can China get rid of their dollars? Their options are fairly limited:
- They can start buying more from us than they sell to us. We’ve been trying to get them to do this for years! Seems unlikely.
- They can buy from us, stuff priced in dollars, but only sell goods to us that are priced in Yuan. To get Yuan, a US purchaser would have to sell dollars to buy Yuan. Since China doesn’t want to be the other side of that trade (which would leave them with the same amount of dollars), the US purchaser would have to go elsewhere to buy Yuan. This would strengthen the Yuan. This is also something we’ve been trying to get them to do for years! The Bank of China stops the Yuan from strengthening against the dollar by…selling Yuan and buying dollars. Hmmm.
- They can just hit the bid and sell dollars against all sorts of other currencies. This would greatly weaken the dollar, and is perhaps the biggest fear of many of the people worried about de-dollarization.
Supposing that China decided on #3, they would be making US industry much more competitive around the world against all of the currencies that China was buying. Foreign buyers of US products would now be able to buy US goods much more cheaply. It would cause more inflation in the US, but it would take a large dollar decline to drastically increase US inflation since foreign trade is a smaller part of the US economy than it is for many other countries.
A much lower dollar, making US prices look lower to non-US customers, would help balance the US trade deficit. Yay!
A tendency towards balance of the trade deficit would have ancillary impacts. When the US government runs a fiscal deficit, it borrows from essentially two places: domestic savers and foreign savers. Foreigners, having a surplus of dollars (since they have trade surpluses with us), buy Treasuries among other things. If the trade deficit went down drastically, so would foreign demand for US Treasuries. That in turn would (unless the government started to balance its fiscal deficit) cause higher interest rates, which would be necessary to induce domestic savers to buy more Treasuries. Or, if domestic savers were not up to the task, the buyer of last resort would be…the Federal Reserve, which could buy those bonds with printed money. And that’s a really bad outcome.
Now, does any of this cause a collapse of the American system or spell an end to US hegemony? No. If policymakers respond to such an event by refusing to get the fiscal house in order, then things could get ugly. But it would be hard to blame that outcome on the end of the dollar as the medium of international trade – blame would more appropriately be directed at the failure of domestic policymakers to adjust in response.
In the end, it is hard to escape the idea that good or bad economic and inflation outcomes in the United States track mainly, one way or the other, back to domestic policy decisions. Whether the US economic system remains a dominant one is…fortunately or unfortunately…in our hands, not in the hands of foreign state actors.
Summary of My Post-CPI Tweets (March 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but subscribers to @InflGuyPlus get the tweets in real time and a conference call wrapping it all up by about the time the stock market opens. Subscribe by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
Note that since the post-8:30am charts were tweeted rapidly and commentary added to it by later re-tweets, the summary below is rearranged to eliminate the redundancy and improve readability.
- Welcome to the #CPI #inflation walkup for April! (March’s CPI figure)
- A reminder to subscribers of the tweet schedule: At 8:30ET, when the data drops, I will post a number of charts and numbers, in fairly rapid-fire succession. Then I will retweet some of those charts with comments attached. Then I’ll run some other charts.
- There is a small wrinkle this month: I am going to be a guest on a Twitter space hosted by @Unusual_Whales while I’m busy tweeting. That shouldn’t impact you subscribers. Tune in if you want!
- After the tweeting dies down, I will have a private conference call for subscribers where I’ll quickly summarize the numbers. After my comments on the number, I will post a partial summary at https://inflationguy.blog and later will podcast a summary at inflationguy.podbean.com .
- I will also record that call for later call-in if you’re not available (and of course later there will be my tweet summary, and my podcast, so you can consume my opinions however suits you).
- Thanks again for subscribing! And now for the walkup.(Some of this I’ve related over the last few days and am summarizing/repeating here.)
- The whole banking-collapse thing seems to have blown over for now, but interest rates are still lower than they were a month ago. And breakevens are higher. This is one reason stocks are doing well – steady infl expectations and lower real yields is a sweet cocktail for equities.
- It’s also likely fleeting, but it helps explain why the market is doing so well for now.
- Today’s CPI print might be very interesting. There are a lot of crosscurrents and everyone seems to be interpreting them differently. The spread isn’t super wide, but the swaps market is almost a full 0.1% below economists’ estimate for headline inflation.
- (The swaps market tends to be more accurate than economists in this regard, but I hope this month they aren’t because I have the over.)
- The drag on inflation is not going to come from food; raw foods are again spiking and there’s still the wage issues for food-away-from-home. I have gasoline adding 3bps, while some others see it flat or subtracting slightly. But the big drag is piped gas.
- As I noted on Monday, piped gas is part of household energy and normally it is too small to matter. But the massive recent decline pulled down February CPI and should pull down March. I have the effect worth 13bps.
- But also, lower utilities implies that primary rents will have a small tailwind UPWARD and most people will ignore that. The reason it happens is the BLS backs out utilities when rents include utilities, so sharply lower utilities implies slightly higher rents.
- Anyway, that’s the big drag. But why does the swap market see it as so much bigger than economists do? That’s odd. Or it could imply the Street sees a real drag on core…but that’s a hard sell right now.
- Last month, Used Cars did not rise along with the private indices, but those indices rose again and so it’s likely we’ve seen the end of the price retracement from Used Cars. Indeed, Core Goods is showing signs that it is not going to gently go to -1%.
- Heck, in my view the economists are too low on core anyway – they’re 0.05% below the traders on Kalshi’s core inflation market, and 0.1% below me. Is it possible we can get 0.4% or lower on core? Sure. But there are a lot of upward pressures.
- This chart shows median wages minus median CPI. For years, it has been stable at about 1%, other than in the aftermath of disaster. Right now it isn’t, b/c Median CPI is still rising while median wages have ebbed although just a little.
- Now, this chart might say something different to you than to me. My interpretation is that employees will fight against further declines in wage growth, until inflation comes down. But you might argue that this gives room for CPI to decelerate.
- Since we are focused on the wage-price feedback loop in core-services-ex-shelter (as I was saying long before the cool kids dubbed it “supercore”), the resolution of this question is very, very important.
- Anyway, I think we will see 0.5% on core inflation. But even if we only see 0.4%, y/y core will rise. Not many will get too exercised about that, though, because the easy comps are coming. By May, we will likely see y/y core start declining again.
- Of course, I’m focused on median CPI, which is still hitting new highs. But it also should start ebbing soon. As always, the question is “how much” and I continue to say “not as much as the market is pricing in.” With breakevens in the low 2s, they’re very cheap in my view.
- We will see what the number brings. But unless it’s even higher than I have it, and with an alarming breadth, I think the Fed is likely done hiking. As I said last month, 25bps doesn’t do anything at this stage anyway.
- But +0.5% on core will be taken very badly by the stock market, I think, and probably pretty bad for bonds as well. Everyone wants fervently to believe with the inflation swaps market that this inflation episode is over.
- Doesn’t look like it to me. Not yet! Good luck today and I’ll be back live at 8:31ET.
- Definitely better than expected. Swap market as usual is closer than economists…and core was actually was .053%
- m/m CPI: 0.053% m/m Core CPI: 0.385%
- Kneejerk observations: Used Cars dragged again (?). RENTS WERE SHARPLY LOWER FROM TREND. Medical Care was a drag.
- Last 12 core CPI figures
- Inflation Swap market gets closest-to-the-pin. In fact, Headline rounded UP to 0.1%. Core was actually kinda close to expectations (but lower than I thought!).
- M/M, Y/Y, and prior Y/Y for 8 major subgroups
- The big story here is going to be housing. Housing 0.3% m/m is a big decline. Some of that is piped gas, but…
- Core Goods: 1.53% y/y Core Services: 7.13% y/y
- Now, notice that core goods turned up. That’s even though CPI for Used Cars declined. Again, that is unexpected since private surveys have said used car prices are going back up.
- Primary Rents: 8.81% y/y OER: 8.04% y/y
- …still not peaked, but peaking? Actually y/y higher this month, so it’s possible there’s some seasonality issue.
- Further: Primary Rents 0.49% M/M, 8.81% Y/Y (8.76% last) OER 0.48% M/M, 8.04% Y/Y (8.01% last) Lodging Away From Home 2.7% M/M, 7.3% Y/Y (6.7% last)
- (This really is the big story today. Actually, core being that high despite housing…is surprising.)
- Actually core ex-shelter rose very slightly to 3.81% y/y.
- Here is my early and automated guess at Median CPI for this month: 0.401%
- Some ‘COVID’ Categories: Airfares 3.96% M/M (6.38% Last) Lodging Away from Home 2.7% M/M (2.26% Last) Used Cars/Trucks -0.88% M/M (-2.77% Last) New Cars/Trucks 0.38% M/M (0.18% Last)
- Piece 1: Food & Energy: 2.63% y/y
- A lot of the recent plunge here is piped gas…which is just about done.
- Piece 2: Core Commodities: 1.53% y/y
- Piece 3: Core Services less Rent of Shelter: 5.53% y/y
- Supercore coming down! But just a little. Still not sure this is thrilling enough for the Fed.
- Piece 4: Rent of Shelter: 8.26% y/y
- The distribution here is going to be really important. Unfortunately my data scraper is having a strange issue and that feeds my distribution stuff. Obviously the middle shifted, which is why median CPI decelerated, but I want to see the diffusion stuff. Tech delay for me…
- Piped gas actually fell only -8.0% m/m NSA, versus -9.3% last month. I thought it was going to be greater, so there was a slightly SMALLER drag on headline than I expected there.
- Also encouraging is that Food and Beverages was only 0.02% m/m. I’m a little surprised by that, but it’s good news. Non-core of course.
- I will say the bottom line is that IF the housing data is real, then this is a really happy inflation number. But outside of the housing data…core was still 0.4%! So not GREAT data. The distribution data will be important, which is why it’s even more frustrating atm.
- I can also report that the biggest decliners in core m/m were Car/Truck Rental (-37% annualized monthly change), Energy Services (-24%), Misc Personal Goods (-14%) and Used Cars/Trucks (-10%). Latter I’ve already mentioned is really odd.
- Biggest gainers are Public Transportation (+46%), Lodging Away from Home (+38%), Motor Vehicle Insurance (+16%), Mens/Boys Apparel (+13%), and Personal Care Products (+10%).
- We are obviously not going to have the conference call today…too late to be of any use. But I have some thoughts anyway about the Fed and the positive market reaction.
- Totally understand the positive market reaction. The headline figure ALMOST rounded to unchanged, and core was a little light although not very much. The rally makes sense.
- The dive in longer-term breakevens doesn’t, as much. If you think this big deceleration in shelter is real then it means inflation is probably peaking even in a median sense…but long-term breakevens already impound a 2.2% average inflation rate.
- There is nothing to make me think that rents are going to go flat, with median wages rising at 6% and home prices advancing again. This is not 2009-10 and there is still a big shortage in shelter and plenty of income to support rents. So 2%…is still very unlikely IMO.
- That said, let’s think about the Fed. Start from the premise that their model is assuming high-frequency rent data is predictive, even though it’s been predicting rent deceleration for a long time and this is the first sign of it.
- But if your null is “I’m waiting for rental inflation to turn” and then you see a sign of a turn…well, it’s bad econometrics to “confirm” a hypothesis but that’s how humans work. I think this makes a further hike fairly unlikely unless the Fed wants to make a symbolic gesture.
- With Fed funds at 5% and at least SOME concerns about banking, the juice doesn’t seem to be worth the squeeze to hike again. Which is, of course, why markets are ebullient today.
- I don’t think we’re out of the woods on inflation yet. I should have missed this number by a LOT more than I did given I was 0.25% off on the largest part of core. It means the strength is still broad.
- But the question has never been “WILL inflation go back down someday.” It has been about WHEN. And how far…but not so many people are questioning that when it goes back down, it’ll go to 2%.
- There’s just no natural reason that should happen. It’s a pleasant wish, but there’s no mechanism to cause inflation to go to the Fed’s target naturally. And as I’ve shown recently, there’s actually not much evidence that inflation mean reverts at all…even if the mean IS 2%.
- So…good news today, and the Fed will take it as such. As will markets. But here is the chart of m/m primary rents. This doesn’t seem entirely plausible to me. Give me another month or two and I’ll be a believer.
- Anyway, thanks for tuning in, and bearing with me despite the tech issues. I will update the diffusion index when I get the problem fixed.
Today’s inflation data was clearly positive, but how positive it is depends on whether rents are suddenly decelerating in the way the data says they did in March. That seems implausible to me, but it’s possible. As I said above, the question was never whether inflation would stop going up, but when, and how far it falls back. We thought median inflation had peaked in September, and then it went higher. It now looks like it has peaked again – and this is likely the case. But we’ve been fooled before.
Here’s a crucial point to keep in mind, though, when we are predicting Fed action. What’s their null? If my null hypothesis is that inflation is unlikely to slow below 4%, say, then I need a lot more evidence before I stop hiking rates. I know that many of you reading this fall into that camp. But does that mindset characterize the central bank’s thinking? What I think we know about the Fed right now is that they are moderately (but only moderately) concerned about the banking system; they are concerned about core services ex-shelter because of the wage-price feedback loop I’ve been highlighting since long before they did; and they believe that higher-frequency data on rents suggests that rent inflation should be ebbing ‘soon.’ Chairman Powell has said all of these things.
So if that’s the case, how does it frame today’s data?
There’s nothing new in this about banking. But there does seem to be information which would confirm what I am assuming to be the Fed’s ‘priors’ about rents. To me, that one month doesn’t mean a lot, but to someone who has been expecting a deceleration, this probably looks like one. There’s also nothing here about wages per se, although “supercore” is decelerating some. However, I think the Fed already believes wages are declining, because they tend to focus more on “Average Hourly Earnings” from the Employment report. That’s a terrible measure, but it’s widely used. (In fact, for most economic data you want to ignore “average” measures if the composition can change a lot from report to report, like the employment report can). Here’s a chart of AHE, against my preferred measure of median wages of continuously-employed persons, from the Atlanta Fed (in blue).
If I’m right and the Fed is focusing on the black line rather than the blue line, and I’m right about how they are thinking about rents, then I think if you took a poll of Fed thinkers you’d find that most of them think they’ve broken the back of inflation and the only question is how quickly it gets back to 2%. I suspect most of them would prefer to keep rates where they are, and not lower them quickly, because you want to keep the pressure on…but I believe the argument for pushing rates a lot higher is substantially weakened by recent data – that is, if you share those priors.
My view is unchanged, although I will keep an eye on rents. My model has them coming down to 4% or so, but then my model never had them getting much higher than 5%. Some of that is an overshoot thanks to the correction after the eviction moratorium was lifted, but a lot of that in my opinion is supported by the big shortage of shelter and by strong wage growth. I’m not sure why we’d expect rents to fall drastically, especially if a landlord’s cost of financing and of maintenance are still rising. Overall, I think inflation is in retreat thanks to a contracting money supply although that is offset by the rebound in money velocity. But I don’t expect inflation to get to 2% any time this year or in 2024. More likely, we will settle in around 4%-5% later this year. That’s my null hypothesis!
