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My Quick, Early Opinion About the Warsh Nomination
Before I tell you what I think about Trump’s nominee for Fed Chairman, Kevin Warsh, I should first confess to the fact that my opinion of Chairman Powell has changed several times since he was first nominated. That’s a user-beware warning about my thoughts below, but it’s not just about me. I’ve watched the Fed since about 1990 – I wrote a book leaning against the perception of Chairman Greenspan as some kind of “Maestro” – but what happens when individuals meet institutions is that both are changed. The classic example is that Presidents always govern closer to the middle than their campaign rhetoric, but it is a general rule.
In Powell’s case, I was initially very optimistic. Powell was a non-economist, the first such to have led the Fed since G. William Millers’ brief tenure prior to Volcker. “Maybe,” I thought, “Powell will be less likely to automatically buy into the assumptions of the poorly-performing models the Fed has used for the last few decades, and move away from them. My opinion fairly quickly shifted once he became Chairman and made it abundantly clear that he had basically learned everything he needed to know about monetary policy from the existing staff at the Fed. Total regulatory capture, in other words. And he moved too slowly when COVID hit and it was very obvious that inflation was going to spike given the government’s efforts to keep demand strong with lots of money, while supply had collapsed. He was totally Team Transitory, and totally wrong.
But then, the Fed actually started raising rates, and raised them far more than I thought that a traditionally-dovish institution was going to. My opinion of Powell rose again. Yes, it was exactly inverted to the right approach – instead of raising rates and letting the balance sheet stay large, he should have kept rates low and slashed the balance sheet – but he at least thought he was being hawkish. My opinion of him took a final turn lower, when his Fed made nakedly-political interest rate moves in the runup to the 2024 election.
In the end, I rank Powell well above the disastrous Yellen and the disconnected-from-the-real-world Bernanke, but below Greenspan. Indeed, while I don’t think Greenspan was any part of a “Maestro,” and he changed the Fed in some incredibly damaging ways (making it far too transparent)…I feel kind of bad in retrospect for my book since his three successors have all been worse.
Anyway, that is a long prologue but let’s face it, we have far more information about Powell than we do about Warsh. I want it to be a warning, though, about the fact that whatever I/we think today about Warsh, we should let his future actions inform our opinions!
So here’s what I think…and I am only telling you because some of you asked:
I think Trump could have done a lot worse than Warsh. While the President regularly confounds his critics by making solid decisions when they expect the ravings of a madman, this one surprised me too. For all his railing about how interest rates should be lower, and the Fed was moving too slowly, etcetera, he ended up choosing someone who is certainly on the hawkish side of the ledger…certainly with respect to the other people supposedly being considered.
Now, Trump isn’t wrong when he says the Fed did not manage the inflation spike or its aftermath very well. As I’ve said for a long, long time, managing inflation is about managing the money supply – and interest rates have nothing to do with inflation. I don’t think Trump is being this nuanced, but it’s the right answer: shrink the balance sheet, rein in money growth in other ways…and lower interest rates, because one thing we do know is that money velocity is influenced by interest rates. That’s how you get a non-inflationary boom, and it would be funny if Trump got there by accident. (Or…is it?)
But this is the way Warsh is supposedly leaning: near-term dovish, but hawkish on the balance sheet. Also important, as I alluded to earlier when talking about how the Fed has become more and more transparent: allegedly Warsh tends towards less communication about policy. If you want to de-lever the dangerously levered global financial system, a great place to start would be to decrease the predictability of monetary policy. More visibility = more risk taken, which increases systemic risk.
One of the things I hope for Warsh is that he ignores Bill Dudley’s advice, given today in a Bloomberg column. Dudley’s #1 piece of advice was “first, he has to win the confidence of his colleagues at the Fed. Although the chair directs the Fed’s staff and sets the agenda at each meeting of the policymaking Federal Open Market Committee, ultimately he has just one of 12 votes. To truly wield power, he’ll have to earn respect. He’s made this more difficult with his persistent criticism that the central bank needs “regime change” and that he might need to “break some heads.””
The incoming Chairman should completely ignore that. It’s nonsense and Dudley knows that. The power to set the agenda is the only power that matters – no Fed Chair has ever been even remotely close to being outvoted, and that’s partly because no Chair would ever call a vote he could lose. Dudley, and all Fed careerists, want to make sure the vast staff at the Eccles Building matters, and that the bureaucracy continues to be what actually sets policy. This is exactly what the President is complaining about, and he is not wrong!
The Fed doesn’t need to be “ended,” but it needs to be a lot more opaque and a lot more introspective about the historical incidence of Fed actions that caused harm versus those that caused good. It needs to be tighter on the balance sheet; overnight interest rates are roughly neutral but don’t really matter that much. At first blush, from my perspective, Warsh falls on the right side of those divides. Casting back to my earlier warning that I am willing and able to have my mind changed on this score as we learn more about the Warsh Fed, I will say at this point that I am pleasantly surprised.
They’re Starting to Come Around on Rent Inflation
For a couple of years, I have been relentlessly defending my forward inflation forecasts against a sizeable group of people who looked at various high-frequency rent indicators and concluded that rents were going to be imminently in deflation. (For most of the last year many of those same people thought tariffs would be a large and immediate effect increasing inflation. Fortunately for them, being wrong on both counts, at least the errors offset somewhat.)
This battle began in early 2023, shortly after the publication of new indices by the Federal Reserve Bank of Cleveland, supported by a paper entitled “Disentangling Rent Index Differences: Data, Methods, and Scope” by Adams, Lowenstein, and Verbrugge. Those authors parsed the BLS rent microdata to separate out the new tenants, and created a “New Tenant Repeat Rent” (NTRR) Index that supposedly served as a leading indicator of what all rents were going to do. Naturally, NTRR had peaked early and was heading down sharply, which reinforced the observation from things like Zillow, Apartment list, etc that new rents in the aftermath of the post-eviction-moratorium catch-up were declining.[1]
The San Francisco Fed also published a piece in mid-2023, entitled “Where is Shelter Inflation Headed,” by Kmetz, Louis, and Mondragon. Don’t get me wrong, I love it when people try to create better models of inflation processes. But this was another one that made just terrible forecasts, because (as in the former case) it was put together by econometricians who didn’t understand the actual underlying process and thought they could just torture the truth out of the data. They included this wonderful (and subsequently damning, because the Internet remembers everything) chart.
Accompanying that chart was the helpful clarifying statement, in case you didn’t get the import: “Our baseline forecast suggests that year-over-year shelter inflation will continue to slow through late 2024 and may even turn negative by mid-2024.”
In case you were curious, it didn’t turn negative; in mid-2024 it was a bit above 5%.
So back then is when I had to start defending a fairly simple premise: the behavior of landlords when they offer rents to new renters does not necessarily mirror what they offer to renewing renters. In fact, I could be even more strident – landlords could not offer lower rents to everyone, even if they offered them to new renters. That’s because a landlord needs to cover his costs or he won’t be a landlord for long. And in 2023, the costs for a landlord were still rising very rapidly – labor, energy, insurance, taxes, maintenance, and so on. My model – first presented in Enduring Investments’ Quarterly Inflation Outlook in August 2023 – suggested that rents were going to decelerate, but much more slowly than others were forecasting. I had them as low as 3% by mid-2024 before flattening out, and even that turned out to be too aggressive on the disinflation side.
By now, regular readers are familiar with this model and familiar with the fact that it still is calling for Rent of Primary Residence to hang around the current 3% level for quite a while yet. Want ‘em lower? Lower landlord costs.
But this article isn’t meant (only) to pat myself on the back. I also want to recognize when someone gets it right and the great inflation analysts at Barclays recently published an article entitled “Apples and oranges in the CPI basket: Why market rent gauges mislead on shelter,” by Millar, Sriram, Giannoni, and Johanson. It is marvelous article, and you have access to Barclays Live and care about this topic you should read it. While they don’t build a cost-plus model like I did, they got to many of the core reasons why looking at new-renter indices is bound to be misleading. My favorite charts from the piece are below (I also had these in my recent CPI report).
What my model does is tell you why that had to be the case: landlords can’t just lower rents on their whole renter base if their costs are increasing. The only exception to that would be if there had been significant overbuilding such that there was a surplus of apartments over the demand from renters. In some places, especially those currently experiencing a negative immigration shock, that may be the case (although those places happen to also be the ones experiencing large increases in insurance costs, so it’s not quite that easy). But nationwide, there is not a surfeit of apartments for rent. Ergo, no rent deflation. And it’s going to stay that way for a while.
One final note here, about the recent Trump announcement that the Administration desires less institutional ownership of single family homes and apartments. I say ‘desires,’ even though that isn’t how it was phrased, since there appears to be no obvious way that the Administration can force this. They are reportedly looking into whether antitrust regulations can be used to keep institutions from accumulating very large portfolios of shelter units, but this looks like (at best) a task for the legislature, not the executive. But let’s consider quickly what the effect would be if Trump got his way in this regard.[2] Institutions which own homes and apartments don’t hold them off the market. That would be terrible carry. They rent them, just as landlords do. If you forced institutions to divest single-family homes, it would simply move supply from the rental market to the owned-home market. That would probably drive home prices a little lower, relative to the prior baseline, but increase rent growth at the margin. This doesn’t seem productive!
[1] I talked about NTRR in a July 2023 episode of my podcast: Ep.74: Inflation Folk Remedies
[2] Honestly, I don’t think he really means to do this. Some amount of what the President says – especially the impossible things – are intended for consumption by voters. I could be wrong on this. Mr. Trump does have a way of making things happen that didn’t seem possible initially, but in this case there’s probably not much he can do and anyway it wouldn’t have a big impact anyway.
Modeling Shortfall Risk versus Inflation – What a Good Hedge Looks Like
When people ask me about hedging inflation, they aren’t always asking what they think they’re asking. There are two approaches to addressing inflation in your portfolio so that the portfolio grows in real terms. One of the approaches is to try to simply outrun inflation: “If inflation averages 3%, and I have an investment that averages 5%, I’ve succeeded.” This mode of thinking derives, I think, from the fact that all of our education has been in nominal space and in most financial modeling problems inflation is just assumed rather than modeled as a random variable. It turns out to be a lot harder than it sounds to find an asset class or collection of asset classes that dependably beat inflation over moderate (10+ year) periods, because there is significant (inverse) correlation between inflation and the performance of many asset classes. Most obvious here are stocks and bonds, so if you build a 60-40 portfolio that “should” return 5% over the long term and figure that will beat inflation, you’ll be right…as long as inflation stays low. If inflation goes up, you won’t only lose purchasing power but you’ll lose actual nominal value, since equities and bonds both tend to decline when inflation goes up. Let’s put that aside for a second but I will come back to it.
The other approach to addressing inflation is to try to hedge inflation: exceed inflation by a little bit, but all the time, so that your returns go up when inflation goes up and your returns go down when inflation goes down, but you always are experiencing some positive real return.
The difference between the first approach and the second approach can be summarized by thinking about shortfall risk. As an investor, you care about the upside (in real terms) but most of us are risk-averse meaning that we care more about the downside. Ask most people whether they’d risk a 25% loss in their portfolio purchasing power to have a similar risk of gaining 25%, and they will experience a strong preference to avoid that coin flip. Risk aversion isn’t linear, so investors treat small gains and losses differently from large gains and losses, and of course it matters whether you’re barely covering your goals or easily exceeding them so that you’re ‘playing with house money.’ Many things, in other words, affect risk preferences. But the bottom line is that if you are trying to ‘hedge’ inflation, you care about your shortfall risk over some horizon. What is the probability that you underperform inflation – that is, lose value in real terms – by some given amount between now and a stated horizon?
Now we are going to get a little mathy, but for those who aren’t so mathy I will try to explain in English as well.
If you want to evaluate the probability of asset B underperforming asset A by some given amount over some period, of course you need an estimate of the expected returns of A and B, or how they’re expected to drift relative to one another. That determines your jumping off point. Let’s suppose that A and B have the same expected return. The next thing that determines the frequency and severity of a shortfall of B versus A is the volatility of the spread between them, which is driven by (a) how correlated A and B are, and (b) how volatile each of them is. If they are highly correlated but B is far more volatile than A, you can have a large shortfall if B just has a bad day. If they aren’t very correlated, then when B happens to zig lower as A zags higher, you’ll get a shortfall even if they have similar volatilities. Essentially, we are valuing a spread or Margrabe option and like any option, we need a volatility parameter. In this case, it’s the volatility of the spread we care about, so we can evaluate “what’s the likelihood that the B-A spread is negative.”
If “SA” is the value of an inflation index (or an indexed token like USDi), and “SB” is the value of the hedging asset, then if distributions of A and B are approximately normal,[1] the option value is
C = SA N(d1) – SB N(d2), where
and
and, crucially, is the volatility of the ratio of A to B, which is a formula that will be familiar to travelers in traditional finance and depends on the individual asset volatilities and the correlation () between them:
For this ‘shortfall’ option to be as small as possible, assets A and B should have small volatilities () and a high correlation () between them.
In plain English terms: imagine two drunk guys walking down the boardwalk. What determines how far away they are from each other at any given time? Assuming no drift, it will depend on how much they’re weaving (volatility) and how much they’re weaving in the same pattern (correlation). If they’re holding hands (imposing high correlation), they’ll never get too far away from each other. And if neither one is very drunk (low volatility) they also won’t stray very far from each other. On the other hand, if both are wildly drunk and they don’t know each other, the spread between them will be wildly variable.
We aren’t trying to evaluate the spread between drunks, though. Let’s take this thought process and apply it to the inflation-hedging problem with an example. Suppose you are considering which of two assets is a better ‘hedge’ for inflation: the “INFL” ETF, or a mystery fund – let’s call it “EUSIT.”[2] Here is relevant data for these two assets, and for CPI. These are 3-year returns, volatilities, and month/month correlations, ending November 2025:
Using this data, we can see that the spread volatility (the result of the last formula listed above) for INFL versus CPI is 15.2%, while the spread volatility for EUSIT vs CPI is 1.1%. The Mystery Private Fund is the drunk holding hands with the other drunk, with neither of them that drunk; but INFL is really smashed (14.9% vol) and tending to zig when the CPI drunk zags (negative correlation).
Let’s extend this out one year, assume that INFL, EUSIT, and CPI all have the same expected returns, volatilities, and correlations. Practical question: What is the probability that your investment in INFL or EUSIT underperforms inflation?
For INFL: based on prior returns, it is expected to outperform CPI by 8.99% (11.97% – 2.98%). With a spread volatility of 15.2%, underperforming inflation (a spread of 0% or less) would mean an outcome that is 0.59 standard deviations below the mean. The probability of a draw from a normal distribution being 0.59 standard deviations below the mean is about 33.5%, which means that if you hedge your inflation exposure with INFL, you’ll underperform inflation about one year in three. Your chances of underperforming inflation by 10% or more in a given year is about 18%.
For EUSIT: based on prior returns, it is expected to outperform CPI by 3.15% (6.13% – 2.98%). With a spread volatility of 1.1%, underperforming inflation (a spread of 0% or less) would mean an outcome that is 2.86 standard deviations below the mean. The probability of a draw from a normal distribution being 2.86 standard deviations below the mean is about 0.66%, which means that if you hedge your inflation exposure with EUSIT, you’ll underperform inflation for a full year about once every 151 years. Your chances of underperforming inflation by 10%…even by 5% for that matter…is essentially zero.
Put a star by this paragraph: the assumptions here are key and I am making no claims about either of these strategies having those same characteristics going forward. This is only to illustrate the point that if you want an inflation hedge, meaning that you want to minimize shortfall risk, then it is very important to look at the volatility and correlation to CPI of your intended hedge. Having a better return is important, but less important than you think it is: at a 5-year horizon, the INFL ETF would be expected to outperform inflation (if we think 12% and 3% are decent long-term projections too) by about 60% compounded, but the spread standard deviation is now 15.2% times the square root of 5 years, so you’re only about 1.76 standard deviations above zero and thus you still have an 8% chance of underperforming inflation at the 5-year horizon! On the other hand, your chance of outperforming inflation by a huge amount, if you use the Mystery Fund, is also very small while that possibility exists if you use INFL. That’s what a hedge does: you give up the possibility of big outperformance to ‘buy back’ the chance of underperformance. If you are risk averse, that is a good trade because you’re giving up the less-salient part of your gains (big outperformance) to protect against the more-salient part (big underperformance).
So getting back to answering the question that we started with: what does a good inflation hedge look like?
- It has highly positive correlation to inflation at whatever horizon you’re focused on
- It has low volatility
- It outperforms, or at least doesn’t underperform, inflation over time
To this, I’ll add a fourth characteristic. It’s almost humorous, because hedges that fit those three characteristics are themselves quite rare. But the fourth one I would add is that it has convexity to higher inflation; that is, it does better at an increasing rate, the higher inflation gets. An inflation option, in other words.
Most of us should be happy with three! But at least now you’ll know how to evaluate whether you’re really getting a hedge, or something that will hopefully perform so well that you won’t care that it isn’t a hedge.
[1] I also conveniently wave away some complexities like the relative growth rates and the time value of money to make the math clearer with respect to volatility and correlation, which is my point here.
[2] Mystery fund is a private 3(c)1 fund available to verified accredited investors via a subscription agreement.
Mamdani’s Effect on the CPI
Surprising no one, and yet shocking many, avowed socialist Zohran Mamdani won the election yesterday to become Mayor of the largest city in the United States.[1]
Probably the main reason for Mamdani’s victory is that he pursued the tried-and-true method of giving out free stuff, and a whole generation of Americans who have systematically been poorly educated in history and economics said “that sounds awesome.” So, now we will see whether socialism will work for the first time ever.
This is an inflation blog, so I want to review briefly the effects of price controls on inflation – and indirectly, on inflation instruments. It’s interesting because we actually have some direct and recent experience with what were effectively price controls: the Biden Administration’s ‘eviction moratorium’ during COVID, that prevented landlords from tossing out renters who weren’t paying their rent. Really, it’s a pretty amazing thing that says a lot about Americans that the vast majority of renters continued to pay rent anyway.[2] An ancillary effect, though, was that landlords had no leverage to raise rents and therefore, rents stopped going up. Unsurprisingly (and here is where the lesson should have been learned), when the eviction moratorium was lifted rents re-accelerated. In the chart below, note how in 2021 effective rents declined while asking rents went up – but the red line eventually rebounded and exceeded the prior trend.
I actually haven’t looked at that chart in a little while. It’s fascinating to me that ‘asking rents’ (which come from the Census department) have maintained their divergence from ‘effective rents’ (sourced from Reis Inc). I wonder if some of that is the effect of the LA wildfires. In any case, not today’s article. The point is that the effective price controls on rents did have an effect on measured rents, but it didn’t change the economics and eventually prices caught up.
Back in 2022, I produced an excellent podcast episode entitled Ep. 37: Bad Idea of the Year – Wage and Price Controls. In it, I discussed some of the trial balloons that had been floated by the Administration and some of the really bad economics that was being used to support the idea. This is a part of the transcript (from Turboscribe.ai), and I still love the analogy:
“But the basics of how it works are very simple to visualize. Price is a teeter-totter, okay? It’s a seesaw. On one side of the seesaw sits all of the buyers. On the other side sits all of the sellers. If there are lots more buyers jumping onto one side, then the teeter-totter drops on that side, and the fulcrum, in order to make everything balance, the fulcrum has to move. And if you move the fulcrum, then you can get that to balance even with more buyers and fewer sellers.
It just means that the fulcrum, which is price, has to move in one direction. If then people, those buyers drop off, then the fulcrum moves back the other direction. If more sellers jump onto the teeter-totter, the fulcrum moves the other direction as well.
So it’s a simple way to visualize it…and yes, there are all kinds of complexities in the real world. There’s behavioral, there’s stickiness that happens, but that’s the fundamental theory of price, is what I’ve just given you, is that price is the fulcrum that balances the buyers and sellers.
So what price controls say is that, well, we don’t like where this balanced. We have too many buyers, not enough sellers, and the fulcrum has moved way over to one side and we don’t think it should be there. So we’re going to take the fulcrum and we’re going to move it to where we like it. And guess what happens? There’s no balance. All of a sudden, if you move the fulcrum away, then all of a sudden, the side with all the buyers goes down and goes thunk on the ground. There’s no balance.
“How do you then balance it? If you say that the fulcrum has to be in this location, how do you balance the teeter-totter? Well, you have to take buyers away. And you take buyers away by making a shortage. And so those buyers can’t buy anything. And then voila. So if you force the price, then the quantity has to change. And if you let both things happen, then it will magically go and balance. If it’s truly a free market and there’s good information and all that stuff.
“So does this solve the problem to push the fulcrum to one side and say, oh, there’s no inflation and to make it balanced, we shove everybody off the teeter-totter by creating a shortage? It doesn’t solve the problem. And furthermore, the people that you’ve pushed off the teeter-totter who can’t get access to the thing anymore are pretty upset. They should be upset because before they had a way to get what they wanted and what they were willing to pay for. And now they can’t because you’ve shoved them off the teeter-totter. You’ve created a shortage.”
That was a public service announcement, just to remind you why price controls don’t work. That doesn’t mean they aren’t really good politics, especially if you can leave the removal of the controls to the next guy who ‘causes’ the inflation when they come off. And it’s the politics, not the economics, that leads to this dumb idea being tried over and over despite a roughly 0% record of success.[3]
Because can price controls affect price indices? You betcha. If you make it illegal to move prices, then at least official prices will not move. So let’s consider the potential impact of Mamdani freezing rents and grocery prices, for example.
New York City is about 7% of the CPI sample. Technically, it’s New York-Newark-Jersey City but we know most of that is NYC. In the New York consumption basket, Rent of Primary Residence is about 11%, 28% is Owners’ Equivalent Rent, and 8% is Food at Home. So, if rents and grocery prices were frozen, about 19% of the NY CPI would go to zero month/month right away (at least officially – the best tomatoes will be sold on the black market for a premium of course and the best catch of the day will be sold in NJ…[4]) And since OER is based on a survey of primary rents, eventually 47% or so of the NY CPI basket will go to zero price change. I’m ignoring the quality adjustments in the housing stock, which have the effect of increasing OER inflation slightly.[5]
The effect of this on the national CPI: if 47% of the NY basket goes from, say, 4% inflation to 0%, and NY is 7% of the national CPI, then the really-rough effect on the US CPI would be 47% x -4% x 7% = -13bps per year. Obviously that’s extremely rough, but I’m just aiming for an order of magnitude calculation. 13bps is small, but noticeable. Probably not tradeable.
But here is something that’s interesting and potentially tradeable. New York City is about 30% of the Case-Shiller 10-City Home Price Index. Let’s suppose that home prices in New York over the next year drop, say, 10%.[6] That move would cause the nationwide Case-Shiller (10-city) index to drop 3%, or to rise 3% less than it otherwise would. Here’s what is interesting. The chart below shows the February 2027 NYC Metro Case-Shiller futures contract, which trades on the CME (and settles to the index for December 2026, which is released in February 2027).
There has been exactly zero price effect of the Mamdani victory. To be sure, open interest in the NYC contract – in all of the Case-Shiller contracts, for that matter – is extremely low but there is an active market-maker and the current price as I write this is 344.40 bid/351.60 offer. The last print of the S&P Cotality Case-Shiller New York Home Price NSA Index, for August 2025, was 334.08. On the bid side, then, the market is paying 3.1% higher prices than the current index. That seems sporty to me. Why would home prices rise if rents are frozen? Why would they rise if people are leaving the city?
As always, my musings here are not trade recommendations; do your own research. Disclosure: I do not currently have a position either long or short in any housing futures contract, nor does any account or fund that I or Enduring Investments manages, nor do I currently have plans to initiate any position.
[1] New York, at least for now.
[2] At the time, we worried about what would happen with the CPI since a renter paying zero rent is not skipped but the rent goes into the calculation as a zero. So you could in theory have had 10% of the basket going to zero, which would have destroyed the inflation market.
[3] If you listen to the episode: I also love my thermometer analogy.
[4] Also, though rents will stop rising the quality of the apartments will deteriorate since landlords will skimp on maintenance. Mamdani has a plan for that, though – he has said the city will order maintenance to be done and if it isn’t, the city will seize the property. Just in case there was any question who really owns any property that you can’t pick up and transport elsewhere.
[5] N.b. – the increase in the CPI nationally from the owned-housing quality adjustment almost exactly cancels the decrease from quality/hedonic adjustments in other parts of the CPI. Yet another reason that the whining about hedonic adjustment being used to ‘manipulate CPI lower’ makes no sense.
[6] You can easily make a case for a much steeper drop if the city increases property taxes to make up for declining income tax collections, not to mention if the exodus from the city looks anything like the 9% of the population who claim they’d move if Mamdani won, or if the finance industry continues to relocate to Dallas and Miami.
When and How Much Tariff Effect?
As we look forward to the CPI report next week, the monthly-repeating theme is ‘when will the tariff effect show up?’ The answer, so far, is ‘not yet,’ but economists who had forecasted the end of life as we know it when the Trump tariffs went into effect have been befuddled.
I’ve already admitted in this column that I was educated in the tradition of ‘tariffs bad,’ but that over the years Trump’s insistence otherwise has made me carefully re-think of which ways tariffs are truly bad, and which ways they’re not so bad. Naturally, if tariffs were uniformly bad – which seems to be the orthodoxy – then it would be really hard to explain why almost every country levees tariffs. Maybe forty years ago we could blame the benightedness of those poor policymakers in other countries, who clearly just didn’t understand how bad tariffs are. But now? Heck, all someone in one of those countries needs to do is ask ChatGPT ‘are tariffs bad,’ and they’ll learn!
… Conclusion: Tariffs can be useful tools in specific, limited circumstances — like protecting vital industries or responding to unfair trade practices. But long-term, high or broad tariffs often do more harm than good, especially in highly interconnected global economies. (ChatGPT, July 9, 2025 query ‘Are tariffs bad’)
But it seems every country has these specific limited circumstances! It’s evidently only bad when the US does tariffs. And that is what made me ask whether maybe there is some nuance. My 2019 article “Tariffs Don’t Hurt Domestic Growth” was really good, I thought.
Even as there has been some small movement in the economintelligencia, though, about whether tariffs are all bad there has been very little movement in the notion that they are clearly inflationary. No doubt, implementing a tariff will raise prices at least a little, but how much is the important question. And regardless of that answer, tariffs are a one-time adjustment to the price level even if that effect is smoothed over a period of time. (This is why it’s weird to hear Powell say that the Fed can’t ease because they’re waiting to see the effect of the tariffs on inflation. That’s economic nonsense. The Fed can’t possibly believe that keeping rates high is the proper response to a one-time shock.)
On this question, I thought I’d share something I wrote in our Quarterly Inflation Outlook from Q1 (in mid-February), in which I roughly estimated the effects of a 20% blanket tariff. I know the answer isn’t “right,” because that’s the wrong question – there isn’t a 20% blanket tariff. But I undertook the estimate to get an idea of the relative scale of effects. (I included in the piece some parts from that 2019 article mentioned above, because I’m not above stealing from myself!) I will add some concluding thoughts after this ‘reprint’ from our QIO – which, by the way, you can subscribe to here.
Tariffs as a Tool to Promote Domestic Growth and Revenue
In the President’s view, the fact that the U.S. has a very low tariff structure compared to the tariffs (and arguably VAT taxes) that other countries place on U.S. goods is prima facie evidence that the U.S. is being taken advantage of and treated unfairly on world markets. The U.S. has, for the better part of a century, been the main global champion of free trade and this tendency accelerated markedly in the early 1990s (as the familiar chart below, sourced from Deutsche Bank, illustrates well).
The effect of free trade, per Ricardo, is to enlarge the global economic pie. However, in choosing free trade to enlarge the pie, each participating country voluntarily surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off. To the extent that a person is a citizen of the world, rather than a citizen of a particular country – and the Ricardian assumption is that increasing the pie is the collective goal – then free trade with every country producing only what they have a comparative advantage in is the optimal solution.
However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the U.S. went through a period of being incredibly bad at automobile manufacturing, there are still several very large U.S. automakers. On the other hand, the U.S. no longer produces any apparel to speak of. In fact, the only way that free trade works for all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability, and permanently at peace so that there is no risk that war could create a shortage in a strategic resource, or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself and/or to establish the conditions that ensure permanent peace by being the dominant military power and enforcing peace around the world. We would argue that (b) is what happened, as the U.S. was willing to let its own manufacturing be ‘hollowed out’ in order to make the world a happier place on average.
The President (and many of those who voted for him) feel that (b) is inherently unfair, or has reached extremes that are unfair to U.S. citizens. Essentially, the President is rejecting the theoretical Ricardian optimum and pursuing instead a larger slice for his constituents. This is where reciprocal tariffs (where the U.S. matches the tariff placed on its exports by a trading partner, with a tariff placed on the imports of that product from that trading partner) or blanket tariffs (where the U.S. imposes a tariff on all imports of a product irrespective of source – e.g. aluminum – or on all imports from a given trading partner) come in.
Blanket tariffs are good for domestic growth,[1] but definitely increase prices for consumers. How good they are for growth, and how much prices rise, depends on how easily domestic un-tariffed supply can substitute for the imported supply and also on whether your country is a net importer or exporter, and how large the export-import sector is in terms of GDP. Because this is an inflation outlook, let’s make a very rough estimate of the impact on the overall domestic price level of a blanket 20% tariff (such as the one Treasury Secretary Bessent has proposed). We suppose the average elasticity of import demand in the U.S. to be 3.33[2] and the elasticity of export supply to be 1.0[3]. In that case, the incidence of a tariff falls about 23% on consumers: [1.0 / (3.33+1.0) ]. So, for a 20% tariff, prices for the imported goods would be expected to rise about 4.6% (20% tariff x 23% incidence). However, imports only account for about 15% of US GDP, which means the effect on the overall price level would be 15% x 4.6% = 0.69%.
So, for a 20% blanket tariff on imports, Americans should expect to see a one-time increase in the overall price level of something on the order of 0.7%, smeared over the period of implementation. This is not insignificant, but it is also not calamitous. It does affect our estimates for 2025 and 2026 inflation, shown in the “Forecasts” section (somewhat less than 0.7%, because we do not expect a blanket tariff but rather reciprocal and targeted tariffs). Also note that the retaliatory tariffs on US exports have no direct effect on domestic prices, so that whether or not trading partners retaliate is irrelevant to an analysis of first round effects, anyway.
Thus my wild guess back in February was that a 20% blanket tariff would result in a bit less than 0.7%, smeared out over 2025 and 2026. That doesn’t answer the ‘timing’ question, but the delays in implementation (so as to not affect Christmas 2025 prices of the GI Joe with the Kung-Fu Grip) and the importer/retailer initial reaction to try and absorb as much as possible for optics – presumably, easing price increases into the system later – mean that it shouldn’t be shocking that we haven’t seen a big effect yet. My point in the above calculation, though, is that we really shouldn’t expect to see a big effect, regardless.
For what it’s worth, the Budget Lab at Yale estimates that currently “the 2025 tariffs to date are the equivalent of a 15.2 percentage point increase in the US average effective tariff rate,” so if we take my 0.7% guess for 20% then we would be looking closer to 0.5% in total. And in fact, lower even than that since the 15.2% average will have less impact than a 15.2% blanket tariff, assuming that the tariffs will be highest where domestic substitution is easier.[4]
Wrapping this up, let me make one final observation. Current year/year headline CPI inflation is 2.35%. The inflation swaps market, specifically the market for ‘resets’ where you can trade essentially the forward price level, currently suggests that traders expect y/y inflation to rise to 3.29% over the next six months: almost 1 full percentage point from here. But that actually flatters what the market is pricing, because the shape of the energy curves suggests that rise is being dragged about 20bps lower by the implied moderation in energy prices (give me a break, inflation traders: I’m doing this in my head).
So, the market is pricing core inflation peaking about 6 months from now, about 1.2% higher than it currently is. Not all of that is the effect of tariffs; some is due to base effects as the very low May, June, and July 2024 numbers roll off of the y/y figure. But if we get that result, you can be sure that economists will put most of the blame on Mr. Trump, while Mr. Trump will put most of the blame on Mr. Powell. Either way, I think the interest rate cuts that the President would prefer are unlikely unless growth takes a significant stumble.
[1] …but bad for global growth! There is no question that unilaterally applying tariffs to imports is bad for all suppliers/countries providing those imports. If Ricardo is right, the overall pie shrinks but the domestic slice gets larger…at least for the dominant players who already have a large slice. If everyone raises tariffs in a trade war outcome, the less-productive countries suffer the most loss of growth and the most-productive countries likely still benefit. But prices rise for all.
[2] Kee, Nicita, and Olarreaga, “Estimating Import Demand and Export Supply Elasticities”, 2004, Figure 5, available at http://repec.org/esNASM04/up.16133.1075482028.pdf Your answers may vary!
[3] Estimates are wildly all over the map, depending on the exporting country and the product. In general the smaller the country, the more price-inelastic it is. We chose unit elasticity here (a 1% increase in price cause a 1% increase in the quantity supplied) just to be able to get a rough guess.
[4] To be fair, the Budget Lab at Yale also estimates the effect on PCE inflation of a whopping 1.74%. They must be really surprised at the impact so far.
Talkin’ ‘Bout the China Gold (Whoa Oh)
I ran this chart in the Quarterly Inflation Outlook released 3 weeks ago or so.
Here’s what I wrote:
In general, gold behaves like a very-long-duration inflation-linked bond with a zero coupon. This makes sense – if we were to issue a bond that, in exchange for the current gold price, offered to pay the bearer no coupons but redeem for 1 ounce of gold in 100 years, it would have the same payoff as holding one ounce of physical gold for 100 years. If gold is a true inflation hedge over time, which means its price rises with the price level, then that bond would have the same payoff if we defined the payoff not in terms of an ounce of gold, but in terms of the change in the price level over that 100 years. And that would be a 100-year zero-coupon TIPS bond.
So, we tend to see over time that the spot gold price tends to track pretty well to the implied price of a zero-coupon TIPS bond. The chart above (Source: Bloomberg and Enduring calculations) illustrates the stark divergence which started roughly when the Fed began its tightening campaign. We do not have a very good explanation for this divergence, other than to postulate a clientele effect in that perhaps gold investors are more animated by inflation and TIPS investors tend to be less-excitable institutional owners. Whatever the cause, at the moment gold represents a TIPS bond that is yielding about -2.25% real yield, or roughly 435bps expensive. Unfortunately, relative value observations like this have no mechanism to force them to close, so we cannot recommend selling gold and buying TIPS as an arbitrage. However, we are comfortable saying that investors could create a significantly better-performing commodity index by leaving gold out of the index, or by replacing gold in the index with a TIPS bond. Call Enduring Investments if you are interested in creating such an investment!
At the time, I wasn’t aware (because I don’t track gold flows – gold to me is just another commodity, albeit one that has a very high real duration and a pretty low inflation duration) that China has been buying gold consistently for a year and a half. That only became apparent to me recently when news stories highlighted that China has stopped the accumulation for now. Here is a chart from Bloomberg of China’s monthly gold reserves. It certainly seems as if the timing of the Chinese purchases correspond reasonably well with the divergence in the first chart above.
However, I am not sure that’s the true reason although it is probably a contributor. If you back up and look at China’s reported reserves over the entire period covered by the first chart above, you can see that the recent increase is the largest since 2015…but certainly not the largest on record. Even if the jumps on the chart are due to less-regular reporting updates, the overall rate of increase prior to 2016 was not dissimilar to that of the last 18 months. And yet, that buying did not cause a divergence of any meaningful amount on the first chart above.
So I am back to thinking that this is a broader clientele effect, of people who responded to the biggest spike in inflation in 40 years by buying an asset that historically has sort of a meh history of protecting against inflation over short or medium periods, and a much clearer history of large yield sensitivity. If that’s the case, then while there’s no trigger for closing the gap we should expect that the gap will, eventually, close. Which preserves the implication I mentioned in the Quarterly Inflation Outlook: prudent investors should consider lightening the allocation to gold in their commodity allocations.
As an aside, the title of this piece comes from a song by the Doobie Brothers that I can’t get out of my head now, and hopefully neither will you!
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?
AI: Even a Big Deal is Smaller Than You Think
So, we are back to the argument about whether we have reached a new era of permanently higher growth and earnings, and because of productivity also a permanent state of steady disinflationary pressures.
Live long enough, and you’ll see this argument come around a couple of times. In the late 60s with the “Nifty Fifty” stocks, in the 1990s with the Internet, and now with AI. As a first pass, it’s worth noting as an equity investor that the first two of those eras were followed by long periods of flat to negative real returns in equities. But my purpose here is simply to revisit the important fact that productivity is always improving, so something which improves productivity is normal and not exciting. The question which arises periodically when we see some really golly-gee-whiz innovation is whether that innovation can meaningfully accelerate the rate of productivity growth over time.
Total real growth over time is simply the growth in the labor force, plus the growth in output per hour (productivity). Assuming that the labor force grows at roughly the same rate as the overall population,[1] real GDP per capita should grow at roughly the rate of productivity. The chart below extends a chart which first appeared in an article by Brad Cornell and Rob Arnott in 2008 (“The ‘Basic Speed Law’ for Capital Markets Returns“), updated to the end of 2023Q3. Note that real earnings and real GDP grow at almost the same rate over time – the log regression slope is 2.09% for real per capita GDP and 2.17% for real earnings.
(By the way, although it isn’t part of my discussion here note that the middle line, real stock prices, isn’t parallel. It was, back when this chart first appeared in 2008; the fact that it isn’t any more is obviously attributable to increases in valuation multiples over a long period of time. Discuss.)
A permanent (or at least long-lived) increase in the long-run rate of productivity growth, then, would be massively important. It would mean that GDP per capita – standard of living, in other words – would rise at a permanently faster pace. This is the crux of the question, as I said above and as NY Fed President John Williams said in an interview with Axios a few days ago (ht Alex Manzara):
“One way to think of it is AI is – and this is my own, but based on what I heard from others – is AI is just that new thing that’s going to get us that 1% to 1.5% productivity growth that we’ve been getting for decades or even a century.
“It’s the thing that gets us that, just like computers did or other changes in technology and how we produce things in the economy. So it’s just the thing that gets us that 1% to 1.5% productivity growth.
“The other view, which I think has some support, is AI is more of a general purpose technology. …So there is a possibility that we could get a decade or more faster productivity growth if this really is its general purpose and revolution. You can’t exclude that.”
What Williams said, about AI being a “general purpose technology” that spurs faster productivity growth for a decade or more, is something that we honestly have a pretty good history of. The explosion of the internet into general use in the late 1990s triggered an equity market bubble that eventually popped. Greenspan mused, in late 1996, that it’s hard to tell when stock prices reflect “irrational exuberance” and in February 1997 he said “history counsels caution” because “…regrettably, history is strewn with visions of such ‘new eras’ that in the end have proven to be a mirage.”
Was it a mirage? There is no question, a quarter-century later, that the internet has completely changed almost everything about the way that we live and work. If there was ever a ‘general purpose’ technology that led to a sustained long-term increase in productivity, the Internet is it.
My next chart only goes back to 1979. It shows US Nonfarm Business Productivity, calculated quarterly by the BLS as part of the GDP report. Obviously, the quarterly numbers are incredibly volatile – so much so, in fact, that I’ve truncated a large portion of the tails. It’s devilishly hard to measure productivity. More on that in a moment. The red line is the 20-quarter (5-year) moving average. The average over the whole period is…surprise!…1.92%, very close to the average increase in real earnings and real GDP per capita. As I said before, that’s what we expected to find.
But there is certainly a bulge in the chart. Noticeably, it doesn’t happen until long after the internet hype had crested, but it is definitely there. The average on this chart from 1979-1998 is 1.78%, and the average since 2005 is 1.59%. But the average from 1999-2005 inclusive is a whopping 3.11%. An acceleration of productivity growth of 1.4% or so, for 7 years, means that our standard of living moved permanently higher by about 10% during that period, over and above what it would have done anyway.
That’s meaningful. I would also argue that it’s probably the upper limit of what we should expect from the AI revolution. Starting in few years, if this is a “general purpose technology” advancement, we could conceivably see growth accelerate by 1.5% per year for some part of a decade. Let’s all hope that happens, because that 10% total growth is the real growth – it is extra growth without any extra inflation. A free lunch, as it were. I say that’s probably the rough upper limit because I can’t imagine how the AI revolution could possibly be more impactful than the internet revolution was, or any of the other major technology revolutions we have seen over the past century.
That’s the good news. If this is real, it would be a wonderful thing and there’s some historical evidence that when the market gets excited like this, it might not be entirely a mirage. Now the bad news. If this is an internet-style leap forward, the aggregate incremental increase in real earnings we should expect compared with the normal trend is…10%. Not a doubling, or tripling, but 10%. Naturally, those gains will accrue to a smaller subset of companies at first, but the other lesson of the internet boom is that those gains eventually percolate around because that’s the whole point of a “general purpose technology.”
Have we gotten our 10% yet? Seems like maybe we have.
[1] This assumption is clearly false, but it’s false in transparent ways. Right now, the population is growing faster than the labor force due to immigration. As Baby Boomers retire, the labor force will grow more slowly than the population. Etc. The assumption here is not meant to be uniformly and universally true, but approximately true on average so as to make the general point which follows. To the extent that this assumption is transparently incorrect, we know how to adjust the general point which follows, for the specific conditions.
Inflation Sherpa
Imagine if you could be a hedge fund investor, or pension or wealth management CIO, thirty-five years ago instead of in 2024. With all of the inefficiencies that persisted before they were exploited and squeezed out by high-frequency trading, automated spread trading, and even fast-moving opportunistic asset allocation models, the opportunity set for alpha was rich and persistent.
Now imagine that there is a market today where such inefficiencies still exist: a market which is poorly understood both at the security and portfolio structure levels, due to the absence of a granular understanding of the drivers of valuation. Wouldn’t you want to be allocating capital energetically to that market? There is such a market: the market for inflation-linked and inflation-adjacent instruments.
If you were going to exploit those opportunities today, you’d need someone who exists on the cutting edge frontier of understanding that market. You don’t want to assail Everest without a sherpa. To explore these opportunities in different forms including long-only, hedge fund, or a factor overlay recognizing embedded bets in a core strategy, you need an inflation sherpa.
To echo the Cents and Sensibililty podcast: you know a guy. If you’re interested, please let me know.
CPI Swaps Improving? Not as Significant as You Think
Today we are going to geek out on inflation derivatives a little more.
Since early 2022, just after the Russian invasion of Ukraine, 10y US CPI swaps have fallen from about 3.15% to around 2.50% (see chart, source Bloomberg).
This is, on its face, pretty remarkable since median inflation during this time has risen from 4.76% in February 2022 to 7.20% in February 2023, and has now ebbed all the way to 6.98%. Core inflation has fallen farther, largely because of the drag from Health Insurance, but is still at 5.5%. Headline inflation has plummeted to 4.9% y/y. There are clearly some base effects that will pull those numbers lower from here, but 10y CPI swaps at 2.50% still looks pretty sporty. After all, you can pay fixed and receive inflation on CPI swaps (aka ‘buying’ the swap) and enjoy positive carry as long as the monthlies are consistently above 0.20% NSA, and six of the last nine have been.
Unfortunately, what you also get when you buy the swap is the negative mark-to-market as 10-year expectations decline. A cursory glance at the market would suggest that the Fed has successfully stuffed the inflation expectations cat back in the bag. Back in 2018, the rolling-10-year-compounded realized inflation rate got as low as 1.37% (granted, this measured from just before the GFC), and even a few years ago it was around 1.60%. If the Fed is putting the inflation genie back in the bottle (I’m working on getting my metaphor count up), then gosh – maybe there’s more downside to inflation swaps.
Or maybe not. Look at the following chart, which breaks down the 10-year CPI swap into the 5-year CPI swap and a 5-year swap, starting in 5 years. We call the former a 5-year “spot” CPI swap; the latter is a 5y5y forward CPI swap. The 5y5y shows us the rate you could lock in today, paying fixed for 5 years and receiving actual realized inflation from June 2028-June 2033.
These two rates have the relationship that
sqrt[(1+5y rate)(1+5y5y)] – 1 = 10y CPI rate
In other words, you can pay fixed and receive inflation in one of two ways: you can pay the 10y rate and receive inflation, or you can pay the 5y rate and receive inflation for 5 years, and simultaneously lock in the rate where you would do the same transaction in 5 years.
Notice that almost all of the improvement in the 10-year rate since early 2022 is in the spot 5-year rate. Now, the spot rate is always more volatile than the forward, because energy is very volatile in the short term but mean-reverting in the long term. For this reason, policymakers often obsess on the 5y5y, which is perceived to be long enough for the energy volatility to wash out.[1] But in this case, pretty much all of the improvement in inflation quotes is coming from the front of the curve. In other words, if inflation expectations were “unanchored” (at least judging from the market, which as we know is a terrible measure of expectations) back in 2022 then they still are, 500bps of tightening later.
That being said, it’s hard to get terribly concerned about this supposed unmooring because if you back up a little farther it’s obvious that market pricing of longer-term inflation is still damaged from way before COVID. The chart below shows 5y5y CPI going back basically to the beginning of the inflation derivatives market.
From 2003 to 2014, 5y5y was never far from 2.75%-3.00%. There were occasional forays down to 2.5%, and occasional jaunts up to 3.25%, but other than the volatility around the GFC it never varied far from that. Today’s level of 2.58% would be at the lower end of the historical range prior to 2015, and at the upper end of the historical range from 2015 to present.
What happened in late 2014? Well, the dollar soared and oil prices crashed from 100 to 50 in a short period of time. Somehow, this led to a structural change in the shape of the inflation curve. In the old language we used to use, the “risk premium” of 5y5y over spot 5y got squeezed out. I suspect it was because of the structural change to lower volatilities, which lessened the value of the ‘tail’ option in long-dated inflation. But…I may be attributing too much sophistication to the market.
Whatever the reason, long-dated inflation quotes appear to me to still be very low. If the Fed achieves a 2% target for PCE, that’s 2.25% or so on CPI and you lose 33bps versus the 2.58% forward. If the Fed moves the inflation target to 3%, as some people are advocating, then you’re ahead by 67bps.[2] And if the Fed just plain misses, you’re to the good by even more. The only way you lose big is if we slip into a pernicious deflation that lasts a decade – and, since all the Fed needs to do is repeat the recent Bernanke-inspired helicopter-money experiment to avert deflation, this would seem to be an unlikely outcome.
Markets trade where risk clears, not at ‘fair value’ or at ‘market expectations.’ What the current level tells you is that not enough people are demanding inflation protection. If you’re one of the people who needs inflation protection, it is still a very good time to get it at a very affordable price.
If you’re an institutional investor or OCIO who needs help on that topic – visit https://www.EnduringInvestments.com and reach out!
[1] N.B. the level of the 5y5y is still positively correlated to the price of gasoline, which is obviously absurd and another example of exploitable error in inflation markets.
[2] (But listen to my latest podcast, Ep. 67 Three-point Goal? Or go for Two? (Percent), where I point out that the Fed currently pursues Average Inflation Targeting in which the official goal is just not terribly important).
