Federal Reserve | E-piphany

Three Colliding Macro Trends

August 2, 2023 Michael Ashton 8 comments

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.

Categories: Bond Market, Credit Spreads, Economy, Federal Reserve, Trade Tags: deficit, onshoring, twin deficits

Enough with Interest Rates Already

June 21, 2023 Michael Ashton 23 comments

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.

Categories: Causes of Inflation, Economics, Federal Reserve, Monetarism, Other Research Posts Tags: core cpi, core inflation, Fed, interest rates

Summary of My Post-CPI Tweets (May 2023)

June 13, 2023 Michael Ashton 3 comments

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.

Categories: CPI, Federal Reserve, Tweet Summary Tags: core cpi, core inflation, CPI, Fed, inflation

Is Inflation Dead…Again?

May 31, 2023 Michael Ashton 3 comments

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.

Categories: Bond Market, Federal Reserve, Trading Tags: core inflation, CPI

Food Inflation Served Hot and Cold

May 4, 2023 Michael Ashton 2 comments

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.

Categories: Causes of Inflation, CPI, Federal Reserve Tags: food at home, food away from home, food inflation

Who’s Afraid of De-Dollarization?

April 19, 2023 Michael Ashton 3 comments

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.

Categories: China, Dollar, Federal Reserve, Theory, Trade Tags: de-dollarization

Summary of My Post-CPI Tweets (March 2023)

April 12, 2023 Michael Ashton Leave a comment

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!

Categories: CPI, Federal Reserve, Tweet Summary Tags: core cpi, core inflation, CPI, Fed, inflation

Summary of My Post-CPI Tweets (February 2023)

March 14, 2023 Michael Ashton 1 comment

Welcome to the #CPI #inflation walkup! To be sure, the importance of this data point in the short run is much less than it was a week ago, but it would be a mistake to lose sight of inflation now that the Fed is likely moving from QT to QE again.
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.
Afterwards (recently it’s been 9:30ish) 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 am also going to try and record the conference call for later. I think I’ve figured out how to do that. If I’m successful, I’ll tweet that later also.
Thanks again for subscribing! And now for the walkup.
This picture of the last month has changed quite a bit over the last few days! Suddenly, rates have reversed and the nominal curve is steepening. The inflation market readings are…of sketchy quality at the moment.

Now, the swap market has also re-priced the inflation trough: instead of 2.65% in June (was in low 2s not long ago), the infl swap market now has y/y bottoming at 3.34% b/c of base effects before bouncing to 3.7% & then down to 3.15% by year-end. I think that’s pretty unlikely.
Let’s remember that Median CPI reached a new high JUST LAST MONTH, contrary to expectations (including mine). The disturbing inflation trend is what had persuaded investors…until late last week…that the Fed might abruptly lurch back to a 50bp hike.
These are real trends…so I’m not sure why economists are acting as if they are still certain that inflation is decelerating. The evidence that it is, so far at least, is sparse.
Also, this month not only did the Manheim used car index rise again, but Black Book (historically a better fit although BLS has changed their sampling source so we’re not sure) also did. I have that adding 0.04%-0.05% to core.
But maybe this is a good time to step back a bit, because of the diminished importance of this report (to be sure, if we get a clean 0.5%, it’s going to be very problematic for the Fed which means it should also be problematic for equity investors).
Over the last few days we’ve read a lot about how banks are seeing deposits leave for higher-yielding opportunities. This is completely expected: as interest rates rise, the demand for real cash balances declines.
You may have heard me say that before. But it’s really Friedman who said that first: velocity is the inverse of the demand for real cash balances. DEPOSITS LEAVING FOR HIGHER YIELDS IS EXACTLY WHAT HIGHER VELOCITY MEANS.
And it is the reason for the very high correlation of velocity with interest rates.
So the backdrop is this: money may be declining slightly but velocity is rebounding hard. Exactly as we should expect. Our model is shown here – it’s heavily influenced by interest rates (but not only interest rates).

And if the Fed is going to move from its modest QT to QE, especially if they don’t ALSO slash rates back towards zero, then the inflationary impulse has little reason to fade.
You know, I said back when the Fed started hiking that they would stop once the market forced them to. What has been amazing is that there were no accidents until now, so the market let them go for it. And in the long run this is good news – rates nearer neutral.
But we have now had some bumps (and to be fair, I said no accidents until now but of course if the FDIC and Fed had been doing their job and monitoring duration gaps…this accident started many many months ago).
With respect to how the Fed responds to this number: it is important to remember that the IMPACT ON INFLATION of an incremental 25bps or 50bps is almost zero. Especially in the short run. It might even be precisely zero.
But the impact of 25bps or 50bps on attitudes, on deposit flight, and on liquidity hoarding could be severe, in the short run. On the other hand, if the Fed stands pat and does nothing but end QT, it might smack of panic.
If I were at the Fed, I’d be deciding between 25bps and 0bps. And the only decent argument for 25bps is that it evinces a “business as usual” air. It won’t affect 2023 inflation at all (even using the Fed’s models which assume rates affect inflation).
Here are the forecasts I have for the number – I tweeted this yesterday too. I’m a full 0.1% higher on core than the Street economists, market, and Kalshi. But I’m in-line on headline. So obviously as noted above I see the risks as higher.

Market reactions? If we get my number or higher, it creates an obvious dilemma for the Fed and that means bad things for the market no matter how the Fed resolves that. Do they ignore inflation or ignore market stability?
If we get lower than the economists’ expectation (on core), then it’s good news for the market because MAYBE it means the Fed isn’t in quite such a bad box and can do more to support liquidity (read: support the mo mo stock guys).
So – maybe this report is important after all! Good luck today. I will be back live at 8:31ET.

Well, headline was below core!
Waiting for database to update but on a glance this doesn’t look good. Core was an upside surprise slightly and that was with used cars a DRAG.
m/m CPI: 0.37% m/m Core CPI: 0.452%
Last 12 core CPI figures

So this to me looks like bad news. I don’t see the deceleration that everyone was looking for. We will look at some of the breakdown in a minute.
M/M, Y/Y, and prior Y/Y for 8 major subgroups

Standing out a couple of things: Apparel (small weight) jumps again…surprising. And Medical Care is back to a drag…some of that is insurance adjustment (-4.07% m/m, pretty normal) and some is Doctors Services (-0.52% m/m), while Pharma (0.14%) only a small add.
Core Goods: 1.03% y/y Core Services: 7.26% y/y

We start to see the problem here: any drag continues to be in core goods. Core goods does not have unlimited downside especially with the USD on the back foot. Core services…no sign of slowing.
Primary Rents: 8.76% y/y OER: 8.01% y/y

And rents…still accelerating y/y.
Further: Primary Rents 0.76% M/M, 8.76% Y/Y (8.56% last) OER 0.7% M/M, 8.01% Y/Y (7.76% last) Lodging Away From Home 2.3% M/M, 6.7% Y/Y (7.7% last)
Last month, OER and Primary Rents had slipped a bit and econs assumed that was the start of the deceleration. Maybe, but they re-accelerated a bit this month. Lodging away from home a decent m/m jump, but actually declined y/y so you can see that’s seasonal.
Some ‘COVID’ Categories: Airfares 6.38% M/M (-2.15% Last) Lodging Away from Home 2.26% M/M (1.2% Last) Used Cars/Trucks -2.77% M/M (-1.94% Last) New Cars/Trucks 0.18% M/M (0.23% Last)
FINALLY we see the rise in airfares that has been long overdue. I expected this to add 0.01% to core; it actually added 0.05%. Those who want to say this is a good number will screech “outlier!” but really it’s just catching up. The outlier is used cars.
Both the Manheim and Black Book surveys clearly showed an increase in used car prices. But the BLS has recently changed methodologies on autos. Not clear what they’re using. Maybe it’s just timing and used will add back next month. We will see.
Here is my early and automated guess at Median CPI for this month: 0.634%

Now, the caveat to this chart is that I was off last month (the actual figure reported is shown), but that was January. I think I’ll be better on February. I have the median category as Food Away from Home. This chart is bad news for the deceleration crowd, and for the Fed.
Piece 1: Food & Energy: 7.97% y/y

OK, Food and Energy is decelerating, but both still contributed high rates of change. Energy will oscillate. It is uncomfortable that Food is still adding.
Piece 2: Core Commodities: 1.03% y/y

This is the reason headline was lower than expected. Core goods – in this case largely Used Cars, which I thought would add 0.05% and instead subtracted 0.09% from core. That’s a -14bps swing. +5bps from airfares, but health insurance was a drag…and we were still >consensus.
Piece 3: Core Services less Rent of Shelter: 5.96% y/y

…and this is the engine that NEEDS to be heading sharply lower if we’re going to get to 3.15% by end of year. It’s drooping, but not hard.
Piece 4: Rent of Shelter: 8.18% y/y

…and I already talked about this. No deceleration evident. As an aside, it’s not clear why we would see one with rising landlord costs, a shortage of housing, and robust wage gains, but…it’s an article of faith out there.
Core inflation ex-shelter decelerated from 3.94% y/y to 3.74% y/y. That’s good news, although mainly it serves to amplify Used Cars…but look, even if you take out the big add from sticky shelter, we’re still not anywhere near target.
Equity investors seem to love this figure. Be kind. They’re not thinking clearly these days. It’s a bad number that makes the Fed’s job really difficult.
Note that Nick Timiraos didn’t signal anything yesterday…that means the Fed hasn’t decided yet. Which means they cared about this number. Which means to me that we’re likely getting 25bps, not 0bps. Now, maybe they just wanted to watch banking for another few days, but…
…the inflation news isn’t good. As I said up top, 25bps doesn’t mean anything to inflation, but if they skip then it means we are back in QE and hold onto your hats because inflation is going to be a problem for a while.
Even if they hike, they will probably arrest QT – and that was the only part of policy that was helping. Higher rates was just accelerating velocity. But I digress. Point is, this is a bad print for a Fed hoping for an all-clear hint.
The only core categories with annualized monthly changes lower than -10% was Used Cars and Trucks (-29%). Core categories ABOVE +10% annualized monthly: Public Transport (+46%), Lodging AFH (+31%), Jewelry/Watches (+20%), Misc Personal Svcs (+17.7%), Footwear (+18%), >>>
Women’s/Girls’ Apparel (+15%), Tobacco and Smoking Products (+13%), Recreation (+11%), Motor Vehicle Insurance (+11%), Infants’/Toddlers’ Apparel (+11%), and Misc Personal Goods (+10%). Although I also have South Urban OER at +10%, using my seasonality estimate.
On the Medical Care piece, we really should keep in mind this steady drag from the crazy Health Insurance plug estimate for this year. It’ll almost certainly be an add next year. Imagine where we’d be on core if that was merely flat rather than in unprecedented deflation.
Let’s go back to median for a bit. The m/m Median was 0.63% (my estimate), which is right in line with last month. The caveat is that the median category was Food Away from Home but that was surrounded by a couple of OER categories which are the ones I have to estimate. [Corrected from original tweet, which cited 0.55% as my median estimate]
I can’t re-emphasize this enough. Inflation still hasn’t PEAKED, much less started to decline.

One place we had seen some improvement was in narrowing BREADTH of inflation. Still broad, but narrower. However, this month it broadened again just a bit and the EIIDI ticked higher. Higher median, broader inflation…and that’s with Used Cars a strange drag.

Stocks still don’t get it, but breakevens do. The 10y BEI is +7bps today. ESH3 is +49 points though!
We’ll stop it there for now. Conference call will be at 9:30ET (10 minutes). (518) [redacted] Access Code [redacted]. I will be trying to record this one for playback for subscribers who can’t tune in then.
The conference call recording seemed to go well. If you want to listen to it, you can call the playback number at (757) 841-1077, access code 736735. The recording is about 12 minutes long.

In retrospect, my forecast of 0.4% on seasonally-adjusted headline and 0.5% on core looks pretty good…but that’s only because we got significant downward one-offs, notably from Used Cars. If Used Cars had come in where I was expecting (+1.4%) instead of where it actually came in (-2.8%), and the rest of the report had been the same, then core inflation would have been 0.6% and we would be having a very different discussion right now.

As it is, this is not the number that the Fed needed. Inflation has not yet peaked, and that’s with Health Insurance providing a 4-5bps drag every month. That’s with Used Cars showing a drag instead of the contribution I expected. The “transitory” folks will be pointing to rents and saying that it seems ridiculous, and ‘clearly must decline,’ but that’s not as clear to me. Landlords are facing increased costs for maintenance, financing, energy, taxes; there is a shortage of housing so there is a line of tenants waiting to rent, and wage growth remains robust so these tenants can pay. Why should rents decelerate or even (as some people have been declaring) decline?

Apparel was also a surprising add. Its weight is low but the strength is surprising. A chart of the apparel index is below. Clothing prices now are higher than they’ve been since 2000. The USA imports almost all of its apparel. This is a picture of the effect of deglobalization, perhaps.

So all of this isn’t what the Fed wanted to see. A nice, soft inflation report would have allowed the Fed to gracefully turn to supporting markets and banks, and put the inflation fight on hold at least temporarily. But the water is still boiling and the pot needs to be attended. I think it would be difficult for the Fed to eschew any rate hike at all, given this context. However, I do believe they’ll stop QT – selling bonds will only make the mark-to-market of bank securities holdings worse.

But in the bigger picture, the FOMC at some point needs to address the question of why nearly 500bps of rate hikes have had no measurable effect on inflation. Are the lags just much longer than they thought, and longer than in the past? That seems a difficult argument. But it may be more palatable to them than considering whether increasing interest rates by fiat while maintaining huge quantities of excess reserves is a strategy that – as monetarists would say and have been saying – should not have a significant effect on inflation. The Fed models of monetary policy transmission have been terribly inaccurate. The right thing to do is to go back to first principles and ask whether the models are wrong, especially since there is a cogent alternative theory that could be considered.

Back when I wrote What’s Wrong With Money?, my prescription for unwinding the extraordinary largesse of the global financial crisis – never mind the orders-of-magnitude larger QE of COVID policy response – was exactly the opposite. I said the Fed should decrease the money supply, while holding interest rates down (since, if interest rates rise, velocity should be expected to rise as well and this will exacerbate the problem in the short-term). The Fed has done the opposite, and seem so far to be getting the exact opposite result than they want.

Just sayin’.

Categories: Causes of Inflation, CPI, Federal Reserve, Monetarism, Tweet Summary, Uncategorized Tags: core cpi, core inflation, CPI, Fed, interest rates

The Powell of Positive Thinking

March 8, 2023 Michael Ashton 7 comments

Yes: Federal Reserve Chairman Powell was very hawkish at his Congressional testimony on Tuesday and Wednesday. He clearly signaled (again) that once Fed overnight policy rates reach a peak, they would not be declining for a while. He additionally signaled that the peak probably will be higher than previously signaled (I’ve been saying and thinking 5% for a while, but it’s going to be higher), and even signaled the increasing likelihood of a return to 50bp hikes after the recent deceleration to 25bps.

This latter point, in my view, is the least likely since all of the reasons for the step down to 25bps remain valid: whether the peak is 5% or 6%, it is relatively nearby and the confidence that we should have that rates have not risen enough should therefore be decreasing rapidly. Moreover, since monetary policy works with a lag and there has been very little lag since the aggressive tightening campaign began, it would be reasonable to slow down or stop to assess the effect that prior hikes have had.

But here is the bigger point, and one that Powell did not broach. There is really not much evidence at all that the Fed’s hikes to date have affected inflation. It is completely an article of faith that they surely will, but this is not the same as saying that they have. Consider for a moment: in what way could we plausibly argue that rate hikes so far have been responsible for the decline in inflation? The decline in inflation has been entirely from the goods sector, and a good portion of that has been from used cars returning to a normal level (meaning, in line with the growth in money) after having overshot. How exactly has monetary policy driven down the prices of goods?

This is not to say that higher interest rates have not affected economic activity, and this (to me) is the real surprise: given the amount of leverage extant in the corporate world, it amazes me that we haven’t seen a more-serious retrenchment. Some of this is pent-up demand that still needs to be satisfied, for example in housing where significant rate hikes would normally dampen housing demand substantially and seems to have. However, there is a severe shortage of housing in the country and so construction continues (and home prices, while they have fallen slightly, show no signs of the collapse that so many have forecast). Higher rates are also rippling through the commercial MBS market, as many commercial landlords have inexplicably financed their projects with floating rate debt and where the cost of leverage can make or break the project.

Higher interest rates, on the other hand, tend to support residential rents, at least until unemployment eventually rises appreciably. I think perhaps that not many economists are landlords, but higher costs tend to not result in a desire to charge lower rents. On the commercial side, leases are for longer and turnover is more costly, but the average residential landlord these days is not facing a shortage of demand.

So where have rate hikes caused inflation to decline? Judging from the fact that Median CPI just set a new high, I think the answer is pretty plain: they haven’t. And yet, the Fed believes that if they keep hiking, inflation will fall into place. Where else can we more plainly see at work the maxim that “if a piece doesn’t fit, you’re not using a big enough hammer?” Or maybe, this is just a reflection of the notion that if you want something bad enough, the wanting itself will cause the thing to happen. [N.B. this is really more in line with the prescription from Napoleon Hill’s classic book “Think and Grow Rich”, but the title of Peale’s equally-classic “The Power of Positive Thinking” suggested a catchier title for this article. Consider it poetic license.]

Moreover, what we have seen is that higher interest rates have had the predicted effect on money velocity. Although I have elsewhere noted that part of the rebound in money velocity so far is due to the ‘spring force’ effect, there is substantial evidence that one of the main drivers of money velocity is the interest rate earned on non-cash balances. Enough so, in fact, that I wrote about the connection in June 2022 in a piece entitled “The Coming Rise in Money Velocity,” before the recent surge in velocity began. [I’d also call your attention to a recently-published article by Samuel Reynard of the Swiss National Bank, “Central bank balance sheet, money, and inflation,” where he incorporates money velocity into his adjusted money supply growth figure. Reynard is one of the last monetarists extant in central banking circles.]

Now, nothing that I have just written is going to deter Powell & Co from continuing to hike rates until demand is finally crushed and, according to their faith but in the absence of evidence to date, inflation will decelerate back to where they want it. But with long-term inflation breakevens priced at levels mirroring that faith, it is worth questioning whether there is some value in being apostate.

Categories: Causes of Inflation, Economics, Federal Reserve, Monetarism Tags: fed chairman, fomc, Powell

The Monetary Policy Revolution in Three Charts

January 18, 2023 Michael Ashton Leave a comment

Over the last few years, I’ve pointed out exhaustively how the current operating approach at the Fed towards monetary policy is distinctly different from past tightening cycles. In fact, it is basically a humongous experiment, and if the Fed succeeds in bringing inflation gently back down to target it will be either a monumental accomplishment or, more likely, monumentally lucky. My goal in this blog post is to explain the difference, and illustrate the challenge, in just a few straightforward charts. There are doubtless other people who have a far more complex way of illustrating this, but these charts capture the essence of the dynamic.

Let me start first with the basic ‘free market’ interest rate chart. Here, I am showing the quantity of bank lending on the x-axis, and the ‘price’ of the loan – the interest rate – on the y-axis. If we assume for the moment that inflation is stable (don’t worry, the fact that it isn’t will come into play later) then whether the y-axis is in nominal or real terms is irrelevant. So we have a basic supply and demand chart. Demand for loans slopes downward: as the interest rate declines, borrowers want to borrow more. The supply curve slopes upward: banks want to lend more money as the interest rate increases.

An important realization here is that the supply curve at some point turns vertical. There is some quantity of loans, more than which banks cannot lend. There are two main limits on the quantity of bank lending: the quantity of reserves, since a bank needs to hold reserves against its lending, and the amount of capital. These are both particular to a bank and to the banking sector as a whole, especially reserves because they are easily traded. Anyway, once aggregate lending is high enough that there are no more reserves available for a bank to acquire to support the lending, then the bank (and banks in aggregate) cannot lend any more at any interest rate – at least, in principle, and ignoring the non-bank lenders / loan sharks. We’re talking about the Fed’s actions here and the Fed does not directly control the leverage available to loan sharks.

Now, traditionally when the Fed tightened policy, it did so by reducing the aggregate quantity of reserves in the system. This had the effect of making the supply curve go vertical further to the left than it had. In this chart, the tightening shows as a movement from S to S’. Note that the equilibrium point involves fewer total loans (we moved left on the x axis), which is the intent of the policy: reduce the supply of money (or, in the dynamic case, its growth) by restraining reserves. Purely as a byproduct, and not very important at that, the interest rate rises. How much it rises depends on the shape of the demand curve – how elastic demand for loans is.

As an aside, we are assuming here that the secondary constraint – bank capital – is not binding. That is, if reserves were plentiful, the S curve would go vertical much farther to the right. In the Global Financial Crisis, that is part of what happened and was the reason that vastly increase reserves did not lead to massive inflation, nor to a powerful recovery: banks were capital-constrained, so that the Fed’s addition of more reserves did not help. Banks were lending all that they could, given their capital.

Manipulating the aggregate quantity of reserves was the way the Fed used to conduct monetary policy. No longer. Now, the Fed merely moves interest rates. Let’s see what effect that would have. Let’s assume for now that the interest rate is a hard floor, and that banks cannot lend at less than the floor rate. This isn’t true, but for ease of illustration. If the Fed institutes a higher floor on interest rates then what happens to the quantity of loans?

This looks like we have achieved the same result, more simply! We merely define the quantity of loans we want, pick the interest rate that will generate the demand for those loans, and voila, we can add as many reserves as we want and still get the loan production we need. The arrows in this third chart show the same movements as the arrows in the prior chart. The quantity of loans is really determined entirely by the demand curve – at the prescribed interest rate, there is a demand for “X” loans, and since banks are not reserve-constrained they are able to supply those loans.

However, it’s really important to notice a few things. The prior statement is true if and only if we know what the demand curve looks like, and if the floor is enforced. Then, a given interest rate maps perfectly into Q. But:

D is not known with precision. And it moves. What is more, it moves for reasons that have nothing to do with interest rates: for example, general expectations about business opportunities or the availability of work.
Moreover, D is really mapped against real rates, while the Fed is setting nominal rates. So, for a given level of a nominal floor, in real space it bucks up and down based on the expected inflation rate.
Also, the floor is not a hard floor. At any given interest rate where the floor would be binding, the desire of banks to lend (the location of the S curve) exceeds the demand for loans (by the amount of the ?? segment in the chart above). The short-term interest rate still affects the cost to banks of that lending, but we would still expect competition among lenders. This should manifest in more aggressive lending practices – tighter credit spreads, for example, or non-rate competition such as looser documentary requirements.

In the second chart I showed, the Fed directly controlled the quantity of reserves and therefore loans. So these little problems didn’t manifest.

Now, there is one advantage to setting interest rates rather than setting the available quantity of reserves as a way of reducing lending activity. Only the banking sector is reserve-constrained. If there is an adequate non-bank lending network, then the setting of interest rates to control the demand for loans will affect the non-bank lenders as well while reserve constraint would not. So this is somewhat “fairer” for banks. But this only means that non-bank lenders will also be competing to fill the reduced demand for loans, and the non-bank lending sector is less-vigorously regulated than the banking sector. More-aggressive lending practices from unregulated lenders is not, it seems to me, something we should be encouraging but what do I know? The banks aren’t lobbying me to help level the playing field against the unregulated.

Hopefully this helps illuminate what I have been saying. I think the final chart above would be a lovely final exam question for an economics class, but a bad way to run a central bank. Reality is not so easily charted.

Categories: Bond Market, Federal Reserve, Theory Tags: loans, monetary policy, Money

Newer Entries Older Entries

E-piphany

Archive

Three Colliding Macro Trends

Like this:

Enough with Interest Rates Already

Like this:

Summary of My Post-CPI Tweets (May 2023)

Like this:

Is Inflation Dead…Again?

Like this:

Food Inflation Served Hot and Cold

Like this:

Who’s Afraid of De-Dollarization?

Like this:

Summary of My Post-CPI Tweets (March 2023)

Like this:

Summary of My Post-CPI Tweets (February 2023)

Like this:

The Powell of Positive Thinking

Like this:

The Monetary Policy Revolution in Three Charts

Like this:

Email Subscription

Recent Posts

Pages

Top Clicks

Archive

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Share this:

Like this:

Email Subscription

Recent Posts

Pages

Top Clicks