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A Price-Linked USD
Let me introduce you, for those who aren’t already acquainted, to the Unidad de Fomento.
The Unidad de Fomento (UF) is an almost-unique currency in the world.[1] It was established in 1967 by Chile as a non-circulating currency – I will get to that in a minute – and has survived a period of hyperinflation and a rebasing of the circulating Chilean currency from Escudos to Chilean Pesos in 1975. That is an amazing testimony.
What is unique about the UF is that it is directly indexed to the price level. The value of the UF increases (or in theory decreases) every day with the inflation index. This means that unlike the actual circulating currency, the UF maintains its purchasing power over time. If you could buy a physical UF, it would be like buying a 1967 Chilean peso. As long as you hold it, you will be able to buy exactly as much actual stuff as you could have in 1967, or for that matter last year. If you put enough UF in your pocket to buy an empanada when the price of an empanada was 1,000 pesos, then when you take it out of your pocket you should still be able to buy an empanada no matter what the price of an empanada is today.[2]
Every day, what is changing is the exchange rate between 1967 pesos and ‘today’ pesos, and the only part of that which is changing is the price level. That is, after all, exactly what a price level means. It means snapshotting the value of this basket of goods and services in, say, 1983 (as for the CPI) and then telling you what roughly the same basket of goods and services (allowing for changes in the consumption basket over time) would cost today. So the NSA CPI today at 314.54 means that if the consumption basket cost $100 in 1983, today the same basket would cost $314.54. Except that if we had a UF for the dollar, we would simply say the basket cost 100 UF$ in 1983 and 100 UF$ in 2024. That’s powerful.
I noted that the Chilean UF is a non-circulating currency. Then what good is it if you can’t actually buy goods and services with it?
The purpose of the UF was to facilitate contracts and wage agreements in a period of inflation uncertainty. When the future price level is unknown, negotiating longer-term agreements becomes more difficult. Consider a labor union negotiating a multi-year labor contract. The union, who is contracting to provide labor at certain future prices, will want larger increases to protect itself from the possibility that those future wages are eroded by higher-than-expected inflation. Management, on the other hand, wants lower increases because agreeing to larger increases if inflation is lower than expected will make its cost structure less competitive. For a short-term contract, the risk on both sides is low. But the longer the term of the contract, the more the risks grow for both sides and the harder it will be to reach an agreement. Where this manifests is that in low and stable inflation regimes, contracts tend to have longer tenors; in high and unstable inflation regimes, contracts tend to have very short tenors or to be completely untenable.
This is the problem that UF solves. The parties to a negotiation no longer have to protect their nominal wages and prices. They have offsetting risks to inflation, so they agree to real wage increases or price escalations by negotiating not in Chilean Pesos but in UF. Then, as time passes, those agreed-upon UF amounts are translated at the then-current exchange rate between UF and Chilean Pesos – reflecting the change in the price level that has actually occurred.
There are many salutatory effects to this. Suddenly, the need to get ahead of wage and price increases and negotiate larger increases to protect against inflation vanishes – and, with it, the feedback loop where higher wages induce higher prices, which in turn induce higher wages. (As I’ve discussed previously here, that doesn’t necessarily accelerate inflation, but it makes inflation much stickier going down than it is going up.)
Why am I mentioning this?
We do not have anything like this in the United States at this point. We have CPI, and companies do negotiate contracts on the basis of CPI. Longer-term construction contracts, such as for power plants or airplanes, often have escalators tied to particular price indices. Frankly, the ability to base a contract on a non-circulating currency is not itself something that is necessary in the USA today[3] although in 1967 in Chile it was. However it has escaped no one’s notice that over time, our currency is a medium of exchange but becomes less and less a good store of value when inflation moves away from the zero bound. Obviously, there are investment products which help address this issue but to the extent that there are any cash balances, higher inflation implies higher monetary velocity partly because the money itself becomes a worse and worse store of value.
One solution to this would be inflation-linked savings accounts, which don’t exist (although I’ve tried to convince people to do that!) Another solution would be to have a currency – a circulating currency – which you could hold which would keep up with inflation. Such a currency would be superior to USD, because it would be USD preserving the purchasing power of the base year.
Why don’t we have such a thing? Well, the US has a monopoly on issuance of its currency, and every time they issue more it is a pure gain to the government, called seigniorage. But that’s not really the reason, because the government would also earn seigniorage on “USDUF.” The real reason is that the USD is a successful fiat currency because, and only because, everyone believes that everyone else will accept it as worth $1. Any new currency, if unbacked, would have to generate trust anew that everyone else would accept the USDUF-USD exchange rate to be equal to the price level. Unless the US government guaranteed that exchange rate by freely exchanging dollars for USDUF on demand, there is no guarantee that USDUF would trade at the appropriate level.
I don’t see the government doing this any time soon. But it really should.
[1] In 2001, Bolivia established a similar currency, the Unidad de Fomento Vivienda, which is based on the same mechanism but is not as widely used as the Chilean UF due to the latter’s long head start.
[2] I am taking some liberties for the sake of illustration. Obviously some goods keep up with the price index, some run ahead and some fall behind…it’s really only true that the value of the UF is constant in terms of the overall consumption basket, not each specific item.
[3] …although having historical financial statements and financial projections in real terms instead of nominal terms, using real discount rates instead of nominal rates, would make a ton of sense and you can show that corporate finance in real space is more efficient and more sensible if there’s any volatility in inflation.
‘Threading the Needle’ Without Vision…or a Needle
From time to time, you will read that the Federal Reserve is trying to “thread the needle” on rates. That is, they don’t want to keep rates too high for too long, lest they sink the economy, nor lower them too soon or too far, lest they reignite (or merely fail to finish off) inflation.
To me, that is a very odd use of the phrase. “Threading the needle” tends to describe a delicate operation that must be conducted with deft precision, since a small error represents a failure. Not to put too fine a point on it (Ha! Ha! Needle pun), but that seems as wholly unlike the problem the Fed is confronting, and the characteristics of the error function.
Let’s think way, way back to 2022 when the Fed began hiking rates aggressively.
The Fed’s first 475bps of rate hikes corresponded with a rise in median inflation from 4.56% to 6.94%, over a period of more than a year, along with accelerating economic growth. The next 50bps must have been the magic number, because Median CPI has dropped 2.6% since March of 2023 and growth has slowed a bit.
Some of this – if you believe that changes in overnight interest rates have an important impact on inflation – might be written off to lags. But historically, the correlation of changes in interest rates with changes in core inflation 12 months later is approximately zero (as I illustrated in this nifty article almost exactly a year ago: Enough With Interest Rates Already).
How is it reasonable to worry about ‘threading the needle’ when the economy does not evidently respond to 50bps, 100bps, or 200bps of rate hikes? Methinks that this is not an apt metaphor.
Part of the problem is that the FOMC doesn’t really know what the target looks like that it is trying to hit. If you fervently believe that interest rates matter, but you don’t know what the lags are or the significance to the economy of 25bps, then how can you be confident that you have the precise control implied by ‘threading the needle?’ Fed speakers have admitted, although they don’t phrase it this way, that they don’t have much control over any of the variables that determine whether or not the target is hit. They’ve specifically noted that monetary policy is not efficacious in bringing down energy prices or moderating food prices, and some have opined that the rapid rate increases might have artificially increased shelter inflation by restricting the supply of homes on offer thanks to trapped mortgagees. Did the Fed rate hikes cause Used Car prices – one of the largest sources of the disinflation to date – to drop precipitously? It seems unlikely.
To thread a needle, you need fine motor control and the Fed doesn’t have it. It was difficult to even get inflation headed in the right direction, and it didn’t happen because of what the Fed did. If monetary policy makers looked at their record objectively, they would have to admit that microadjustments in a policy rate that directly affects very little of the economy do not seem to have much efficacy. If that is true, then the correct policy response is to do nothing unless you are absolutely certain that the direction you need to move policy is unambiguous, and the magnitude you need to adjust policy is substantial. Otherwise, you’re just adding unnecessary volatility to markets.
One thing you learn as a trader is that most of your money is made on very few trades, and so if you are trading frequently the majority of your trading is just noise. Similarly, for most investors it is more important to get the position scaled for proper risk rather than to choose the ‘right’ securities. The odds that you have chosen the best-performing stocks, if you choose just (say) three, are vanishingly small. Market prices may not be completely efficient, but they’re too efficient for most people to beat on a regular basis. Similarly, the Fed ought to make few moves. Most of its activity is just noise…at best. The market is pretty good at moving interest rates to where supply and demand balance, when it is left alone, and market interest rates have a better forecasting record than the Fed by quite a lot. Stop trying to thread the needle.
Inflation Guy’s CPI Summary (Mar 2024)
After a week when the NY/NJ area saw an earthquake, an eclipse, and a gorgeous 75-degree spring day, it is time to get back to work.
Today’s CPI report was not expected to be particularly great. In fact, one of the biggest conundrums of market behavior recently has been the question of why investors seemed to remain very confident that the Fed will cut rates several times this year, even as forecasts for the path of inflation have backed off of what they were last year (when most forecasters had core CPI returning placidly and obediently to the neighborhood of 2% this year). The a priori consensus forecasts for today’s CPI figure were +0.28% m/m on core and +0.33% m/m on headline. The Kalshi market was in line with that, although CPI swaps were a touch lower on headline at +0.29% (seasonally adjusted, but CPI swaps trade NSA CPI). That’s not wonderful: 0.28% on core would annualize to 3.4% y/y.
The assumption has been that even if in March we are annualizing to 3.4%, the coming deceleration in rents will push everything back down to where it needs to be. The problem with this has always been (a) the strongly-held belief that rents would slip into deflation this year were never based on good analysis, and more importantly (b) this assumed that nothing unforeseen would happen in the other direction. It is characteristic of inflationary periods, of course, that bad things happen on the upside. So this was always sort of assuming a can opener,[1] but at least forecasts for the current data were reflecting that these things had not happened yet. To be fair, the consensus on core has been low relative to the actual print for four months in a row, but at least folks are forecasting mid-3s, rather than 2.0.
Now, let’s review one other thing before we look at some charts. The recent story boils down to this: sticky rents, sticky wages. While core goods has been pulling down core inflation, that game was running out of room. The next part of core deceleration relies on un-sticking the sticky rents, and sticky wages.
So here we are. Today’s figure +0.36% on core CPI, +0.38% on headline (seasonally adjusted on both). This makes the last 3 core CPIs 0.39%, 0.36%, and 0.36%. The chart below of the m/m core CPI figures does not really give the impression of a decelerating trend.
We always look these days first at rents, because that is so important to the disinflation story. Rent of Primary Residence was +0.41% m/m, down from 0.46% last month. Owners’ Equivalent Rent was steady, at +0.44%. Remember that there had been some alarm two months ago, when OER for January jumped to 0.56%, that this was due to a new survey method or coverage and it was going to be repeated going forward. That was always pretty unlikely, but now we have had two months basically back at the old level and the January figure appears to be an outlier. 0.41% on Primary and 0.44% on OER is not hot, just sticky. It isn’t going up; it’s just not going down very fast.
Rents will continue to decline. But the failure of rents to slip into deflation is a source…maybe the source…of the big forecast error made by economists about 2024 CPI. Our cost-based model for primary rents, which never got even vaguely close to deflation, has now definitively hooked higher with the low coming in November. Rents haven’t been decelerating as fast as our model had them, but if anything that’s a source for concern on the high side.
Outside of rents, core inflation ex-housing rose to 2.38% y/y. That sounds like “most of the economy is on target,” but that’s not how inflation works. There’s a distribution, and if the ‘rents’ part of the distribution is going to be higher than the target then everything else needs to average something below the target. We aren’t there. And, as I noted above, we’ve squeezed out just about everything we can from core goods. Actually, y/y core goods dropped to -0.7% thanks partly to continued declines in Used Cars (-1.1% m/m) and some decline this month in New Cars (-0.2%). I think the latter might partially reflect discounts on the EV part of the fleet, where cars for sale have been piling up as manufacturers under political pressure have been producing far more of them than people want.
Note that core services, even with the decline in y/y rents, moved higher this month to 5.4% from 5.2% y/y. Some of that was medical care, which was +0.49% m/m driven by another jump (+0.98% m/m) in Hospital Services. The y/y rise in Hospital Services is now up to 7.55% – the highest since October 2010.
Partly driven by hospital services, the ‘super core’ (core services ex-rents) continues to re-accelerate.
Again, this is not what the Fed wanted to see; and it’s driven partly by the stickiness in wages. The Atlanta Fed’s Wage Growth Tracker has decelerated but is still at 5.0% y/y. That’s not the stuff that 2% core inflation is made of.
Let’s take one moment to look at a piece of good news from the report. My estimate of median CPI, which is my forecast variable because it is not subject to outliers like Core CPI, is +0.32% for this month. Because I have to estimate seasonals for the regional housing numbers, actual Median might be a teensy bit higher or lower but in any event the chart of Median CPI is much less alarming than the chart of Core CPI.
I should observe that the news there is not completely good, since a signature of inflationary environments is that tails are to the upside – that is, core is persistently above median. That was true during the upswing, but during the moderation core has gone back below median. But this bears watching, and if core starts to routinely print above median it will be a negative sign. For now, though, the Median CPI is good news. Relatively.
So let’s talk policy.
The Administration always seems to be confused about why, despite strong jobs numbers, consumers consistently report dissatisfaction with the economic situation. There really shouldn’t be any confusion. Consumers, especially those not in the upper classes, hate taxes. And in addition to a high direct take from the government in explicit taxes, consumers are also facing persistent inflation that the Administration says isn’t there. Inflation is a tax, and it sucks worse than direct taxation because you can’t rearrange your consumption very well to avoid it. (You can rearrange your investment portfolio, but a strikingly small number of people seem to have actually done that even three years into this inflation episode. If you’re curious about how, you really should visit Enduring Investments and ask.)
On the other question of policy, and that’s the Fed: I can’t see any rational argument for cutting rates in June. Actually, on the data we have in hand I can’t see an argument for cutting rates in 2024, except for the one the Fed doesn’t consider and that’s that interest rates don’t affect inflation. To cut the overnight rate, the Fed would have to rely on forecasts that inflation is going to get better. And to do that now, when forecasts have been persistently wrong (and not by just a little bit but about the whole trajectory) since 2020, would be incredibly cavalier. The FOMC still consists of human beings, so never say never. And the inflation data should improve as the year goes along and rents moderate. I just don’t see any sign that it’s going to moderate enough to say ‘we’ve reached price stability.’ Sticky in the high-3s, low-4s is still where I think we’re coming out of this.
[1] A physicist, an engineer, and an economist are stranded on the desert island with nothing but a crate of canned food. “How are we going to get the food that is inside of these cans?” asked one. The physicist says “well, we could heat the cans, carefully, in a crucible we make from ocean clays. Eventually the heat will cause the can to burst and we can get the food inside.” The engineer says “that will take too long. What we need to do is take some of these coconuts, raise them up to a great height with a series of ropes I will design, and allow them to smash down onto the cans, breaking them open.” The economist says “I have a solution that is far easier than what you fellows are doing. Here is how we do this. First, assume a can opener….”
Changing the Fed’s Target – FAIT non-accompli?
As the steadier measures of inflation (core, median, or sticky depending on your preferences) have started to overshoot expectations slightly – the y/y measures continue to decline, but slower than expected as the m/m numbers have surprised on the high side – the markets have continued to price Fed policy becoming increasingly easier over the course of 2024 and into 2025. While Fed officials continue to push back gently on this assumption, it seems that most of the FOMC is comfortable with the idea that there will be at least some decrease in overnight rates later in the year and the only question is how much.
While inflation has not been settling gently back to target, there have developed two big holes in the narrative that the Fed was depending on. First, there is no reason to think that rent of shelter is going to cross over into deflation, either in 2024 or any time in the future. The belief that the CPI for rents would follow the high-frequency data into deflation was never well-founded, despite some fancy-looking papers that claimed you could get three pounds of fertilizer out of a one-pound bag if you just squeezed it the right way (I discussed “Disentangling Rent Index Differences: Data, Methods, and Scope”, and why it wasn’t going to tell us anything we didn’t already know, in my podcast last July entitled “Inflation Folk Remedies”), and while rents are declining they are not plunging, and home prices themselves have turned back higher and are growing faster than inflation again.
Second, core-services-ex-rents (so-called ‘supercore’) inflation needed to see wages decelerate a lot in order for that piece to get back towards target. They haven’t, and it hasn’t.
This isn’t to say that these things may not eventually happen, but so far the expectation that we would get back to target sustainably by the middle of 2024 looks quite unlikely. Why, then, are people talking about when the first eases will happen? The only way that it makes sense to do so is if the goal to get inflation back to 2% sustainably is no longer driving policy.
This has led to some observers pointing out that the Fed doesn’t actually have a 2% target any longer. In 2019, the Fed moved to Flexible Average Inflation Targeting, or FAIT. Under this rubric, the Fed doesn’t need to regard 2% (or about 2.25% on CPI) as a target that they need to hit at a moment in time but only as an average over some period of time. This obviates the need for overly-aggressive monetary policy in either direction, such as the instantaneous adjustment linked directly to the inflation-miss that is required by the Taylor Rule.
Unfortunately, under that rule the Fed has little if any chance of meeting its mandate. It would have a better chance of hitting 2% in…um…let’s say a ‘transitory’ way, as rental inflation swings lower and we pass close to the target briefly before inflation goes back up to its new equilibrium level. Back in August 2021 I noted that the Fed was already above the FAIT projected from the announcement of that policy, and in fact had used up all of the post-GFC slack. Obviously, it has gotten worse since then. Below, I update the two charts from that article. The first chart shows the CPI from August 2019, along with the average-inflation-targeting line and the forwards suggested by the CPI swap market (showing where inflation futures would be trading, if they were trading).
The second chart shows the CPI back to January 2013. We’ve made up all of the inflation from the post-GFC deflation scare, and then some.
Note that the inflation swap market is not indicating any expectation that prices will return back to the trendline. The market is acting as if the Fed is still operating under the old rules, where the goal was to get inflation to be stable at 2% from here, wherever “here” is. This means one of four things will have to happen, or it implies a fifth thing.
- The Fed needs to re-base its FAIT to start from the current price level. In that case, the red CPI-plus-2.25% line will shift abruptly upward but then will parallel the inflation implied by the inflation market; or
- The Fed can keep the original base, but concede that the actual target now is 3% (about 3.25% on CPI), which means that if the inflation market is right then it should be back on target by late 2029 (see chart); or
- The Fed can dedicate itself to fighting inflation for much longer, and publicly disavow the notion of reducing interest rates in the next few years. If CPI went completely flat then the Fed would be back on the line by sometime in 2028.
- The Fed can abandon FAIT, because it has become inconvenient, and validate the inflation market’s assessment that the Committee would be happy with 2% from here, not on average.
If none of these things happens, and the Fed then implies that the inflation market is going to permanently imply something different from what the Fed claims to be its modus operandi. In that case, it would be very hard to argue that the central bank had not lost credibility, wouldn’t it?
Four Quick Thoughts on Fed Day
Four fairly quick observations on this Federal Reserve meeting day, not all of which have anything to do with the Fed:
1. The FOMC today announced unchanged policy for now on the overnight interest rate, on the pace of QT runoff, and on the collective expectation of the Committee for the number of rate-cuts in 2024 (three, 25bp cuts). But it beats noting that while three cuts is the median expectation, the mean expectation dropped substantially. Only one official sees four rate cuts in 2024, compared to five who saw that many or more, as of the December survey. Those four folks moved to ‘three’, and one of the ‘three’ folks moved to ‘just one.’ Nine of the nineteen dots are for fewer than three cuts this year, so we should say this is a closer call than the market seems to think.
2. The longer dot plots also show some increase in Committee members’ expectations for the neutral short-term interest rate (the so-called ‘r-star’ originally popularized, I think, by Greenspan). The significance of this for investors and traders is that the overnight rate is unlikely to go back to zero unless we get another enormous calamity; the significance for the economy is essentially nil since it is money, and not interest rates, that matter. I’ve written before about why there are good reasons to think of something like 2-2.25% as the neutral long-run real rate, and so if CPI inflation is expected to be 2.25%-2.5% then something around 4.5% is neutral long-run nominal rate. We are mighty close to that now, so there is no compelling reason to think that interest rates should decline markedly from here. At the short end of the curve, we should eventually be lower – but we need to also keep in mind the growing imbalance in the supply and demand for Treasury paper, which (in the absence of recession) will tend to keep rates on government paper higher than they otherwise would be in equilibrium – and as one consequence, by the way, credit spreads will tend to be lower than they otherwise would be for a given level of creditworthiness.
3. The Fed clearly believes that the situation in Commercial Real Estate (CRE) and its effect on the banking sector is manageable. If they didn’t think so, then they would be hastening to lower rates to ease the refinancing problems that are hitting that sector. I have been reading alarmist analyses saying that the $1 trillion in CRE mortgage maturities due this year will lead to ‘hundreds’ of bank failures. This falls into the Big Number is Bad and Scary school of analysis. One trillion is a lot of mortgages and that will cripple banking! Except…
Let’s suppose that 20% of those mortgages go into default – a number more massive than we’ve ever seen before – and that recovery is 80%. For reference, in the 2008-09 crisis CRE values fell by about 36% according to the Greenstreet Commercial Property Price Index (chart below), and that was against a backdrop of 1%ish inflation. The nominal price decline should be less in an environment where underlying inflation is 4% per year, naturally. Since the CRE peak, real values have fallen 31% but nominal values only about 21% on the basis of that index. But the drop from the peak isn’t the relevant part. Even the shorter loans now coming due were struck 3-5 years ago, and the drop from that level is only about 9%. Plus, the initial loan-to-value levels were not 100%. So (and all of this is just to cuff a rough estimate) a 20% loss when selling out the collateral on a defaulted mortgage seems conservative.
Those numbers mean the $1T in mortgage maturities could produce a loss of $40bln (1,000 * 0.2 * 0.2). That’s still a big number, but remember that it is spread over a lot of banks. Suppose that it is spread over only 2,000 banks, and that the losses have nothing to do with bank size. Then you are looking at losses per bank of $20mm. That’s bad for a small bank, but the losses at a small bank will of course be smaller because they have smaller books. Will that sink ‘hundreds of banks’? Only if they are small, fairly insignificant banks.
Will some banks fail because they lent too much against commercial real estate which has fallen in value, at too-high loan-to-value ratios, and end up owning property that they can’t sell? Almost certainly. But after negotiations and forbearances and the eventual foreclosures – in an environment where the price level is rising 4% per year – I just don’t think this is something we should worry about. To be fair, the fact that the Fed is not worried about it is something that makes me worry about it.
4. I have been befuddled recently because airfare prices in the CPI have been higher than would be anticipated given the movement in jet fuel prices. Belatedly, I think I know what is going on. The issues with Boeing planes has meant that (and I didn’t know this) Boeing has greatly reduced its deliveries to airline companies as they sort out the problems with their Max jets. I became aware of this only recently when a Bloomberg story highlighted how Southwest Airlines is cutting capacity and freezing hiring because they aren’t getting the planes they need. Steady demand and constraints on supply means higher airfares, as I also discovered this week when I was booking a flight to Chicago. Yikes! With jet fuel prices also rising again, this is something to factor into CPI forecasts going forward. It’s surely ‘transitory,’ but it takes a long time to build a plane and in the near-term this is more likely to be solved on the demand side if we have a recession, than on the supply side with a sudden influx of planes.
Rising Mortgage Origination Hints at M2 Turn
One of the successes the Federal Reserve can tout from the last couple of years (and the list of them is pretty short, to be fair) is that after the unprecedented policy actions during COVID caused never-before-seen rates of money supply expansion, subsequent policy avoided normalizing that explosion.
Year over year growth in M2 reached 26.9%. But in 2022, as the Fed started hiking rates and shrinking its balance sheet, the rate of growth slowed until M2 reached its absolute peak in July 2022 and began to slowly decline. As of today’s H6 release, year-over-year M2 has been negative for 13 months in a row.
To be sure, after a massive explosion the level of M2 has not declined all that far as the chart below shows. I also documented this fact back in November in “Where Inflation Stands in the Cycle,” which was really a good piece. You should read it.
So the success of the Fed here can be summarized by saying, ‘at least they didn’t keep blowing up the money supply.’ Since the rise in prices is clearly and closely related to the explosion in the quantity of money we have seen (anyone who still resists this obvious truism after the mountain of recent evidence is added to the prior mountain of evidence), this was a sine qua non for getting inflation back down. It isn’t sufficient, unless it’s continued for a very long time, but it’s necessary. As I illustrated in that article linked to above (which, really, you should read), there are several ways that inflation could evolve from here as the shock to the system gradually unwinds. I’ve talked before about how velocity in the policy crisis behaved as a spring or a capacitor, absorbing a lot of ‘monetary energy’ that is doomed to be released back into the system. Velocity is still rebounding (in Q4, if forecasts for Thursday’s Advance GDP report are accurate, it will rise something like 4% annualized), but if money growth remains negative then that’s really the least-painful way this can resolve. In the last chart from that prior article (have I mentioned it’s worth reading?), slack money growth with decent growth and rebounding velocity is reflected in a movement mostly to the left, with the price level not rising much. Good outcome.
However, that outcome is predicated on the notion that the money supply remains slack. If M2 starts to rise again, then the curve drifts upward and the potential set of outcomes almost certainly involve higher prices. Naturally, I’m mentioning this because of developments that make me concerned on this score.
One thing that I seriously missed in 2022 was the fact that the increase in interest rates helped bring down money supply growth. That’s not at all intuitive, because in general changing the price of a loan tends not to change the demand for a loan by very much – especially when higher inflation is making the spot real interest rate paid by the borrower lower and lower. In other words, I assert with some decent evidence that consumer and industrial loan demand is somewhat inelastic for modest changes in interest rates. Ergo, my belief was that merely raising interest rates would not necessarily cause money growth to decelerate. As it happened, I was saved from my own mistake by the fact that the Fed was also shrinking the balance sheet, which (despite the fact that reserve balances aren’t binding on banks in the current environment, so they are essentially unconstrained in lending) I thought might help money growth to decelerate. Not that I thought we’d keep getting 20% growth, but I didn’t think we would have naturally seen money growth fall below, say, 5%. Fortunately, because the Fed was also shrinking the balance sheet my forecasts were not drastically inaccurate despite being wrongly inspired, and so I forecast 5.1% median inflation for 2023 and we got 5.06%. It’s nice when the ball actually bounces your way.
As it happens, though, for the most part higher interest rates seem to have not affected loan growth very much. C&I loan growth remained strong throughout 2022 and didn’t start to level off until the Fed was just about through tightening, and consumer loans as I expected really only started to level off when the Unemployment Rate started to rise…credit cards, not at all. And that’s because, as I said, most borrowers are not borrowing because they made a NPV calculation that said borrowing makes sense; they’re borrowing because they need to and 1% or 2% or 3% doesn’t really change that calculus very much.
But you know where it did change the calculus a lot? In mortgages. And that’s because a buyer might be reluctant to pay 1% more on a mortgage, but what the buyer also needs is someone who is willing to abandon their awesome loan. As has been noted elsewhere by lots of people, home sales absolutely cratered not because people weren’t wanting to buy but because there weren’t enough people who wanted to sell. So mortgage origination volumes also dried up, as a direct consequence of higher rates. The one large market where interest rates did have a big impact, although not for the reason you’d think, was in mortgages!
You know I wouldn’t say this unless I had a neat chart to show you. Here is the Mortgage Bankers’ Association Purchase index, tracking the volume of new loans for purchasing a home (in black), set against y/y money supply growth, in blue.
Let’s tie this up with a bow:
- Higher rates didn’t affect every kind of loan, but had a big impact on turnover, and thus origination, in one very large loan market: mortgages.
- Lower mortgage origination turns out to have been uncannily correlated with money supply growth. This may or may not be causal, but it at least means that mortgage origination merits consideration as a leading indicator of money supply growth.
- As interest rates have leveled off and even declined some, the housing market is gradually adjusting. We are seeing higher home prices, and mortgage origination has been showing signs of recovering as the chart shows (mortgage origination numbers are released before sales numbers, so expect a rise in home sales coming).
- It is going to be difficult for the Fed to keep the money supply shrinking, if origination of new mortgages rises even a little bit. This doesn’t mean M2 is going to skyrocket, just that it is going to stop shrinking (in fact, it has risen each of the last two months).
- If M2 rises at even a sober 5% pace, combined with money velocity that still has some normalization left, it will be extremely difficult for the Fed to hit its inflation target on a sustainable basis for some time.
And what should you do about it, just in case? For starters, read “Inflation Sherpa.”
Summary of My Post-CPI Tweets (Nov 2023)
Below is a summary of my post-CPI tweets. You can follow me on X at @inflation_guy. 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 December (November’s figure). This is the last month I’ll be doing this live!
- Thanks to all of you who have subscribed, voting with your dollars that this was useful. I’ve suspended all renewals so you will no longer be charged after today. I’m deeply grateful that you participated in this experiment. Thank you!!
- As in the past, if you miss the live tweets, you can find a summary later at https://inflationguy.blog and I will podcast a summary at inflationguy.podbean.com . Those will continue in 2024 after the live tweeting stops.
- For this month, I’m on top of the consensus economists’ forecasts for core, but higher for headline. I left Cleveland Fed out because it’s routinely the worst.
- Here’s a rough sketch of where I get my core. Average of the last 3 core numbers is 0.28%; average of the last 6 is 0.26% but that includes a couple of outliers. Average of the last 6 median CPIs is 0.34%. Roughly, overall trend core is about 0.28%.
- But we have to add 1bp for Health Insurance; and I’m writing in -1% m/m for Used Cars which is a 3bp drag. That’s an abbreviated version of how I get 0.26%, but it’s pretty close.
- A quick word on Used Cars, which I have as a drag but some of the big shops have as a +. Black Book fell about 3.7%, seasonally adjusted, last month. The seasonals are an add back, but the add back is much less than the decline. I might be wrong on this, but I don’t see the add.
- That said, there were several months recently that SHOULD have been an add, and were a subtraction, so maybe some economists are expecting a correction. Or maybe my model is just bad.
- What I am NOT including is any drag from airfares. If you’ve followed these tweets in the past you know that airfares have been quite low for the level of jet fuel prices (see chart, red dot is end-of-Nov fuel and end-of-Oct SA fares)
- This month, jet fuel prices plunged, so I think some people have penciled in a decline in airfares. And it could happen. But all this really does is move fares back in line with the current jet fuel (yellow triangle, if NSA fares were unchanged).
- FWIW, there is no strong seasonal adjustment from Oct to Nov in airfares. They tend to drop in December, but that shouldn’t be in this report.
- Previously, I’d been assuming a boost from airfares moving back in the direction of the trendline. That hasn’t happened. If again the dots move just parallel to the line, the jet fuel drop implies about a -3.3% decline in airfares, which is worth 2.5bps on core.
- So if we get a low number like that, the first place I’m looking is shelter (just because it’s big); the second place is airfares.
- Obviously we’re still going to watch shelter. OER was +0.41% m/m and Primary Rents +0.50% last month. I expect both of those to be lower. On the other hand, Lodging Away from Home should swing in the other direction, so shelter overall should be similar to last month.
- Fair disclosure that my Primary Rents model starts to drop fairly rapidly now, so if I take the number naively then I’d be penciling in 0.32% m/m for Primary Rents. That would be much lower than anything we’ve seen m/m yet. And, anecdotally, I don’t see that yet.
- Finally – my headline ‘forecast’ is higher than others’. And that’s because of piped gas, and because I don’t get fired if I miss. Natural Gas spiked in October; given usual lags that SHOULD mean ‘Piped Gas’ is higher this month.
- That would add 7bps, while gasoline drags about 22bps. But subsequent to that, Nat Gas has dropped sharply. And I don’t think most people want to forecast HIGHER gas and try to catch the zig-zag. Safer to just forecast flat.
- If it’s flat, then my headline is exactly in line w/ CPI swaps: -0.21% m/m NSA, +0.10% SA headline. But if I’m taking the mechanical drag from gasoline then I’m taking the mechanical bump from Natty. (Although to be fair, gasoline passes into CPI directly and Natty doesn’t.)
- Turning to markets. Market movements this month are all lower, as the massive bond rally can be seen in real rates and in breakevens.
- Let’s not lose sight of the fact that the monetary metrics are continued good news. M2 is still negative y/y and q/q. And bank loan growth is also very soft (a lot of that is mortgages though).
- Now, you can kinda think of the ‘potential energy’ as the amount the line moved above some trend…say 5%, 6% money growth or loan growth…and it needs to ‘absorb’ that by being below by a certain amount (or the price level will be permanently higher, which is likely the case).
- How long can money growth be below 0? I’ve already been surprised! But if the market is right about the substantial Fed easing in 2024, then money growth will not stay low enough, for long enough, to get inflation back to where everyone wants it.
- OK, bottom line is that everyone is forecasting a SOFT 0.3% on core, meaning that it will round up and barely keep y/y rounding to 4.0%. If shelter comes in soft or airfares moves with jet fuel, it will be a downside surprise.
- But stocks are already on the roof and bonds are 75bps off the high yields. I am not sure an 0.23% or 0.24% on core will be greeted with a tremendous market rally. But 0.31%…or heaven forbid an 0.34% that turns Core CPI up a tick? That would be ugly.
- Ergo I think a downside surprise is the bigger chance, but the smaller effect. I’d sell the initial pop. An upside surprise: I wouldn’t try to catch the knife. Especially in illiquid year-end conditions.
- So that’s a wrap. Good luck today, and thanks again for your persistent support!
- Humorously, it looks like Twitter changed its authorization hooks again. So the auto chart will be manual again. Wish it could have been smooth for this last month! I’ll do it pretty quickly though.
- Well, +0.097% on SA headline, and +0.285% on SA Core. Higher than expectations, but not by much.
- Immediately jumping out is OER at +0.50%, higher than last month’s +0.41%. Primary Rents +0.48%, down slightly from last month but still wayy above my model. And my model is higher than what the Street has, which has been projecting deflation next year in rents.
- Used Cars was in fact an add. +1.58%, despite a 4% fall in (NSA) retail prices. The BLS seasonals just don’t have that much of a drop off, so it must be that some other survey was showing higher retail used car prices.
Some charts in a minute. BLS blocked everything for a bit.
- Airfares was -0.39%; recall I’d assumed flat despite a large decline in jet fuel. Feel good about that one. But Lodging Away from Home was -0.9% m/m.
- Last 12 Core CPI. The downside momentum is less evident now.
- Major subgroups. I will come back to this. Medical Care was an outlier compared to recent trends. Doctors’ Services rose more than 1% m/m. As I said I’ll come back to that.
- Core goods inflation got to 0, but core services inflation stayed at 5.1% y/y. I continue to think core goods inflation is just about done declining, but Used Cars keeps pulling it slowly lower.
- OER and Primary rents. Yes, they’re decelerating. But wayyyyyyyy less than people expected. 0.50% on OER m/m, and 0.48% on Primary Rents. Lodging Away from Home was the only drag on shelter.
- Some ‘COVID’ Categories:
Airfares -0.39% M/M (-0.91% Last)
Lodging Away from Home -0.93% M/M (-2.45% Last)
Used Cars/Trucks 1.58% M/M (-0.8% Last)
New Cars/Trucks -0.06% M/M (-0.09% Last)
- My early guess on Median CPI is a rise to +0.434%, above 0.4%. As with core, the downside momentum here isn’t clear any more. Leveling out in the mid 0.3s gets us 4.25% or so y/y. Not good enough.
- Piece 1: Food and energy was a bit of a drag. HOWEVER, Piped Gas was +4.05% m/m, which added 0.04% to headline inflation – that’s the main source of the headline miss. I should note, I pointed this out…overall, Energy was a -0.23% drag.
- Piece 2: core goods, back to flat.
- Piece 3: the most disturbing piece, because it’s ‘supercore’ and now hooking higher. This is medical and I’ll come back to it.
- Piece 4 rent of shelter. A loooooooong way to go before deflation!
- Food was +0.22% m/m (SA), after +0.30% last month. Food at home was softer thanks to declining shipping, packaging, and commodities costs: +0.11% SA m/m vs 0.26% last. Food Away from Home remains bubbly thanks to wages: +0.43% SA m/m vs +0.37% last.
- Doctors’ services jumped 0.55% m/m. Y/y, it’s still -0.7%, but this jump contributed to the surprise in core and in ‘supercore’. It’s mostly a payback for the -1% surprise plunge last month.
- Medicinal Drugs was +0.45% m/m vs 0.6% prior. But Prescription Drugs jumped to 3.77% y/y. Have no fear: the Biden Administration just threatened to seize patents for any drug increasing prices too much. https://inflationguy.blog/2023/12/07/beware-the-price-controller/
- Core inflation ex-housing rose to 2.13% y/y, the first sequential acceleration since March. Not alarming at 2.13%, but prior to COVID this was in the low 1s.
- Biggest m/m declines were Mens/Boys Apparel (-26% annualized), Car/Truck Rental (-24%), Infants/Toddlers Apparel (-15%), Womens/Girls Apparel (-13%), Motor Vehicle Fees (-13%), and Lodging Away from Home (-11%). The Apparel decline is seasonal holiday discounting.
- Biggest annualized m/m core increases: Used Cars & Trucks (+21%), Tobacco & Smoking Products (+15%), Public Transportation (+13%), and Motor Vehicle Insurance (+12%).
- I love it when a plan comes together.
- Glancing at the markets, I must say I haven’t the slightest idea why we rallied hard in both stocks and bonds on this data. This is not bullish data.
- Have to point out the inflation swap market nailed the headline figure. You can’t trade core in size, but the Kalshi market going in had it at +0.32%. That always seemed high to me.
- Overall, this was fairly close to expectations but the fact that it was shelter holding it up – which is why Median was high, also – is bad news. The entire mainstream thesis on inflation going back to target DEPENDS on something close to deflation in housing.
- …well, deflation in housing OR calamity elsewhere in services. Thanks to the lags in housing, core inflation is going to drip somewhat lower, but it won’t get below 3% before it is hooking higher UNLESS housing really does belly flop. No sign of that at all.
- I guess the counterargument is “but it’s ONLY housing holding it up.” That’s not really true, though. Actually the far left tail of goods in deflation is getting bigger – but that’s the short-cycle stuff (e.g. core goods) that will rotate back up. Services, housing still high.
- I shouldn’t obscure the good news, which is that the breadth of inflation is narrowing. And the decline in the monetary aggregates is promising. The problem is that we have just SO FAR TO GO and the market anyway is expecting the Fed to take its eye off the ball.
- In conclusion – yes, Virginia, this IS the hard part. Core and Median will drip lower thanks to shelter. That takes us from 4% to what, 3-3.25% in 2024 – before shelter’s disinflation is complete. Then what?
- I continue to expect inflation to settle in the high 3s, low 4s, although continued decline in the aggregates will have me push that a little lower. Maybe we’re mid-3s to high-3s in the medium term now, with cycle bottom around 3%. Is that good enough? Doesn’t feel like it.
- That’s all for today. And all for @InflGuyPlus! Thanks again for subscribing to this channel. Be sure to subscribe to the blog at https://inflationguy.blog and follow the podcast at https://inflationguy.podbean.com or your favorite podcast app – so we’ll stay in touch. Merry Christmas!
This number was a little bit above expectations, led by shelter, Used Cars, and Physicians’ Services. There weren’t a lot of large surprises (Physicians’ Services was an unexpected jump but last month it had an unexpected decline so this is best viewed as a give-back), which helps explain the relatively placid market response. Ultimately, how you feel about inflation these days comes mostly down to shelter although it is worth pointing out that ‘super core’ (core services ex-rent of shelter) hooked slightly higher too.
To get inflation back to target in 2024, we would need one or more of the following to happen:
- Shelter inflation indeed goes negative, as the mainstream forecast expects (but I do not – I believe rents will level off around 3% y/y and then likely rise from there); or
- Core goods goes into hard deflation, of -2%ish. With Used Cars already having given up 17% or so off its highs, it is unlikely to be the driver of that. Apparel? Medicinal Drugs? (chart below shows the striking relationship between the growth in M2 since the end of 2019 and the contour of Used Car prices – driving home again how important a continued decline in the money supply is, if we want inflation to get tame again); or
- Core Services ex-Shelter decelerates markedly. For that to happen, we’d probably need to see wages decelerate a lot more. The chart below shows the Atlanta Fed wages measure (y/y) in black, and ‘supercore’ as Bloomberg calculates it in blue. If you want Supercore down to 2%, then you probably need wages at 3-4%. We have a long ways to go there.
To repeat my recent theme: while the inflation numbers are better, and will keep getting better for a while in 2024 because of easy comps and positive trends, we are into ‘the hard part.’ The current trends do not point to inflation placidly returning to 2-2.25% in 2024, or in 2025 unless the money supply continues to shrink.
And that’s where we run into the issue. The market is pricing in something like 125bps of eases over the course of 2024. While it’s possible that the Fed could cut rates while continuing to shrink the balance sheet (since the Fed funds rate is now just stated, rather than being managed through pressure on reserve balances), it would be very odd for the Fed to do something that looks like easing with one hand and tightening with the other. They’d come under a tremendous amount of criticism for that. While that’s actually my recommended strategy for them, I don’t give it much chance of happening.
So, if that’s not going to happen, then one of two things is going to happen:
- The Fed eases in 2024, and ceases shrinking the balance sheet. This is great for the bond market in the short term, but it would mean inflation probably wouldn’t even get back to 3% on core before re-accelerating. And no one will be able to blame the next increase (probably not a spike) on COVID.
- The Fed does not ease in 2024, in which case at some point the bond and stock markets are going to have to stop pricing loose money. That would of course be very bad for stocks and bonds.
There aren’t any easy ways out. Yes, that’s what “this is the hard part” means!
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.
