Union Power and Inflation
One of the biggest stories of the past week has been the synchronized strike by the United Auto Workers (UAW) against the Big Three auto makers in Detroit. Although so far only 13,000 workers out of the 146,000 who pledge allegiance to the UAW have struck, the strategy of striking against each of the Big Three at the same time is interesting. In the past, the UAW would choose a particular automaker to strike, win concessions from that company, and then use the new contract as the basis to cudgel the other automakers into a similar deal. This would completely shut down one company, but not the entire country’s car-making capacity. In this case, the UAW is significantly impacting operations at all three while not completely shutting down any of them – although the implicit threat is that they could, at any time, do so.
What is also interesting is that the demands of the union are aggressive, not to say ambitious. The union is asking for a 36% increase in pay, implemented over four years…plus a reduction to a 32-hour work-week while being paid for 40 hours. Combined, those two demands represent a 70% increase in compensation per hour for a union employee (or, put another way, assuming that a car can’t suddenly be made with 20% less labor, it means the cost of labor going into the vehicle will increase 70%). Additionally, they want a restoration of defined-benefit pension plans and contracted cost-of-living adjustments, which isn’t included in that 70% figure.
Whether or not the union is able to get a sizeable portion of its demands (so far, the auto companies have offered 20% over four years, but the other components of the deal are at least as important), this clearly stands out as one of the most audacious labor asks of the last quarter-century. The timing should not be surprising. Historically, union size and activism is positively related to the level of inflation (see chart, source BLS).
You might think that unions also strengthen when unemployment is high. This is not as true as you would think: when unemployment is high, the union would be asking a company to deliver jobs even though there is no work to be done and the company’s viability may be threatened by a weak economy. Consequently, union actions in a recession tend to be less vigorous (the UAW in fact points out that they made concessions in the Global Financial Crisis to help keep automakers afloat), and unionization is less valuable to the workers in those cases. But in inflation, the union is asking the company to give more to the workers it has and needs, out of its growing revenues and profits (even though those revenues and profits look less impressive, and may even be shrinking, after inflation). Moreover, while unemployment hurts the workers who are unemployed (and unable to pay union dues, also), inflation hurts all workers. Consequently, it is inflation and not unemployment that energizes unions.
Naturally, this is part of the feedback loop that concerns policymakers. When I talk about the wage-price feedback loop, I’m generally talking about how it manifests in core services ex-shelter (“supercore”), where a large part of the cost of the product is labor. In the case of a car, labor is only about 15% – although the exact figure depends who you ask and whether you’re asking about the percentage of cost or the percentage of price. So a 70% increase in that cost would “only” add about 10% to the cost/price of a new car whereas a 70% increase in the cost of an accountant would raise the cost of getting your taxes done by something pretty close to 70%. However, union power has its own momentum, and it manifests in things like (for example) automatic cost-of-living adjustments and persistent pressure on fringe benefits and pensions from a union whose influence in this sort of environment is growing.
That’s not to say that it’s good or bad – but this is another cost of letting the short-term inflation spike linger on by not addressing it by aggressively shrinking the balance sheet early on. The longer inflation stays higher, the more power unions have. And the more power unions have, the more momentum inflation has.
Summary of My Post-CPI Tweets (August 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup for September (August’s figure).
- At 8:30ET, when the data drops, I will pull down the data and then run a bunch of charts. I think I’ve figured out how to autopost these again, fingers crossed. Then I’ll comment and post some more charts.
- Later, I will post a summary of these tweets at https://inflationguy.blog and then podcast a summary at inflationguy.podbean.com . Thanks again for subscribing!
- This month, after some low prints recently, we’re going to get some higher ones. Not terrible like last year, mind you, but higher. The economist consensus…which I’m again closer to than the swap market estimate…is for a high 0.2% on core and a low 0.6% on headline.
- That will raise y/y headline and drop y/y core (all the way to 4.3%!). Core should also fall again next month due to a harsh comp from Sep 2022. After that, progress will be slower. If there’s progress.
- The last couple of prints have been very low: core of +0.16% in both June and July. These were due to non-repeatable things, and I’ll talk about some of them in a bit.
- But the point is that we’ve gotten most of the positive surprises for a while I think (although I guess that’s the nature of surprises!)
- A positive (drag) today, and ongoing for a while, will be the deceleration in rents. Last month Primary Rents were +0.42% and OER was +0.49%. I am penciling the combined ‘rent of shelter’ in for +0.41% this month. That might be aggressive. But it will keep slowing for a while.
- But there are a few things that are going to be reversing soon. One is health insurance. I wrote about this recently https://shorturl.at/agtCX . It will still drag today but that will reverse in October.
- Used Cars is a little indeterminate. I would have thought it was overdone on the downside but am less sure of that now. Here’s why:
- Black book implies continued downward pressure on used car prices. This is partly because auto finance companies have really jerked back on lending, sharply raising rates along with their cost of funding and actually checking credit occasionally.
- The rates make sense but the rationing not so much – delinquency rates have risen from the 2021 covid-funding inspired lows but are still at normal rates. Anyway the result has been downard pressure on used car prices.
- The rate effect is what people had been expecting from housing – the difference between a 5% car loan and a 0% car loan for 7 years is about 13% higher cost for the non-cash buyer so a budget-conscious buyer lowers his price somewhat as a result. Hasn’t happened in housing.
- But in housing the seller also has a loan with value and so is reluctant to sell at a lower price AND lose the low rate. That symmetry doesn’t exist in autos. I suspect that’s why used car prices have fallen farther than I expected (and I should have seen that).
- The Fed though is done (at worse, ALMOST done), and rates will level off for car loans. So this downward pressure will eventually ebb. And they should end up adjusting to a higher overall price level.
- Used cars will still be a drag today (I have a -3.5% fall in used cars penciled in), but that too should ebb soon.
- The real mystery from last month was airfares. That has been down >8% two months in a row, and the current level is about 15% too low for the level of jet fuel (which is rising).
- Do airfares recover 3%? 8%? 15%? I’m wild-guessing 6% but every 1% is worth 3/4 of 1bp on the core m/m. So I’m projecting it to add 4bps, basically. This is a big source of uncertainty, but mostly on the upside, this month.
- Now, we should also recognize that last month’s CPI was also pretty BROADLY low, which meant that median CPI also printed low.
- That would be wonderful if it happened again (but it’s unlikely). Indeed, between higher headline, core, and median, it will be very easy for some people to get carried away with negativity.
- But still, we’re talk ing about 0.23% on core, maybe rounding up to 0.3% if we get stuff a little high. That’s settling in towards the high-3s, low-4s, which is where I think we are going. But watch the breadth, and median.
- The markets, on net, have done almost nothing this last month. Real yields and nominal yields went up a touch, but longer breakevens and swaps are almost exactly unchanged. Shorter breakevens are wider on the strength in gasoline.
- I think markets recognize that the narrative is turning, from “we are in an inflationary spiral” to “inflation is coming down” to “okay now it gets harder.” And that leaves breakevens a bit aimless for now.
- I do think breakevens are too low!
- Energy is back rising, and this time there’s nothing left in the SPR to hold down gasoline prices. Government deficits are ballooning again, partly because interest costs are skyrocketing.
- Navigation from here, both macroeconomically and in a trading sense, starts to get difficult again. Good luck out there today!
- A bit on the high side. Core 0.278 to three decimals. Working on downloading data now.
- As I said, core was a little higher than expected, but still at the low end of what we’d seen for the prior year.
- CPI for Used Cars and Trucks was -1.23%, less than I expected. Airfares were +4.89% (I had +6%), so in the ballpark.
- M/M, Y/Y, and prior Y/Y for 8 major subgroups
- Core Goods: 0.234% y/y Core Services: 5.9% y/y
- Primary Rents: 7.76% y/y OER: 7.32% y/y
- Further: Primary Rents 0.48% M/M, 7.76% Y/Y (8.03% last) OER 0.38% M/M, 7.32% Y/Y (7.66% last) Lodging Away From Home -3% M/M, 3% Y/Y (6% last)
- Some ‘COVID’ Categories: Airfares 4.89% M/M (-8.09% Last) Lodging Away from Home -2.97% M/M (-0.34% Last) Used Cars/Trucks -1.23% M/M (-1.34% Last) New Cars/Trucks 0.27% M/M (-0.08% Last)
- A little surprising that we aren’t seeing the same effect on New Cars (loan interest rate effect) that we are on used cars.
- Here is my early and automated guess at Median CPI for this month: 0.328%
- OK, this is what I expected. The broad everything-was-soft month was a one-off. Median is still slowwwwwly decelerating, but not collapsing like it appeared.
- Piece 1: Food & Energy: 1% y/y
- The energy story is known – OPEC is cutting supplies in anticipation of weak growth, but so far the main economic driver globally (the US) isn’t having the weak growth. And supplies are low. So headline was bubbly and will probably get more of that next month.
- Piece 2: Core Commodities: 0.234% y/y
- Core Commodities driven lower this month partly by Used Cars of course. But it’s going to be challenging to push it a lot lower. That said, the strength of the USD is putting constant pressure in the traditional way here – but nearshoring is still going to make this sticky.
- Piece 3: Core Services less Rent of Shelter: 3.88% y/y
- This is a little interesting…it’s just a little hook to the upside, but remember one of the big downward pressures here is Health Insurance and that’s due to reverse soon.
- But the other big input is wages, and labor’s recent muscularity along with increases in minimum wage in California is going to keep this from decelerating as much as it ‘needs’ to.
- Piece 4: Rent of Shelter: 7.33% y/y
- This is going to keep decelerating. But not back to zero!
- I had penciled in Rent of Shelter as +0.41%. OER slowed to +0.38% m/m, while Primary Rents (about 1/3 of the impact) was faster this month at +0.49%. But ‘Lodging Away from Home’ dropped about 3%, and that’s why Rent of Shelter was so soft. This should rebound next month.
- Interesting and important dichotomy continues: Food at Home was +0.09% (NSA); Food Away from Home was +0.34% (NSA). The latter is wages. Keep an eye on that.
- Medicinal Drugs was +0.61%m/m. Series obviously bounces around a lot but to my eye it’s creeping higher. I remember in 2020 and 2021 it was confounding that with COVID, there was downward pressure here. Looks like that’s ebbed.
- Doctors’ Services was +0.11% m/m, and remains sort of soft. But Hospital Services (2.3% of CPI) was +0.67% m/m. It had been one of the soft categories last month at -0.44%.
- Lodging Away from Home, as I’d mentioned, dragged down the overall Rent of Shelter. But it’s at the low end of its monthly range of wiggles and will probably add next month rather than subtract.
- Worth pointing out because it’s been in the news. Motor Vehicle Insurance, which is 1.7% of CPI – has been steadily increasing. Causes are higher car prices, and big increases in carjackings as well as some natural disaster losses. This doesn’t look like it’s going away. (charts show m/m and y/y)
- Core ex-housing is down to 2.36% y/y. This sounds low, but prior to COVID it hadn’t been over 2% since 2012. As noted earlier, core goods has squeezed out most good news already and core services – outside of housing – still faces wages growing faster than 5%.
- The biggest-losers list (annualized monthly figures) among core categories is led by Lodging Away from Home (-30%), Misc Personal Goods (-25%), Infants/Toddlers’ Apparel (-20%), and Used Cars/Trucks (-14%).
- Biggest gainers are Public Transportation (+58%), Motor Vehicle Insurance (+33%), Car/Truck Rental (+17%), Footwear (+15%), Car Maintenance/Repair (+14%), Misc Personal Services (+12%).
- The dispersion stuff is actually decent news. Broadly, things are slowing down. That doesn’t mean we are going back to 2% inflation; in fact there are very few signs of that yet. But it does mean that the broad upthrust in the price level is ebbing.
- It would be nice to go back to worrying mainly about relative price changes instead of absolute price-level changes. We aren’t there yet. The volatility of prices, and some of the broad pressures like trade and wages, remind us that we are still in the inflation episode.
- This only FEELS like inflation is low, because we saw what high feels like. But 4% core/median inflation is no picnic. And it will keep correlations elevated.
- Last chart. Here is the weight of categories inflating faster than 4%. Obviously we are getting close to 4% being the median. Now, about a third of the basket is housing so that third is in the >4% category. But if we flip and look at <2%, it’s still not back to the old normal.
- …implication being the same as with the diffusion index, volatility, and correlations – we are on the right path, but not there yet.
- NOW – that does NOT mean that the Fed needs to keep raising rates. That’s fairly ineffective anyway although it looks meaningful in used cars. That’s not the issue though. What the Fed should, and probably will do, is just keep rates steady here. And I think they will.
- The real problem comes later: with burgeoning deficits and upward pressure on long rates (I worried about this here: https://inflationguy.blog/2023/08/02/three-colliding-macro-trends/ ), at some point the Fed is going to be under pressure to start buying Treasuries again.
- That’s a bad path, but it’s going to be hard to resist.
- That’s all for today. Thanks for tuning in! I’ll have the summary posted to the blog in an hour or two, and then the podcast later today. Have a good day.
The CPI number this month delivered broadly as expected (and, as expected, broadly). Used Cars continued to slide, and airfares did not repeat the -8% again. The surprise drop in Lodging Away from Home will likely reverse next month, and airfares will be another add. While Used Cars will remain soggy, we only have one more month of Health Insurance drag of 4bps/month before that reverses.
The upshot is that the balance of this year will likely see more 0.3s for the most part, with some high 0.2s (meaning that it rounds down). The easy lifting on core has been done. Due to base effects core will still drop next month, but after that…it is going to get difficult. Decelerating housing inflation will be a persistent following wind, but all of the other things that were rowing in one direction while housing was rising…are about to be rowing in the other direction. And housing’s drag is already reversing. (If you were looking 12 months ahead at the possible future declines in rents, to be fair you should be looking now at 12 months ahead when we’re going to start to see percolating through the re-acceleration that we’re seeing in spot rents and home prices.
There is no need for the Fed to tighten further. Rate hikes don’t really help very much (except in some categories like used cars!) to restrain inflation, and short rates are a bit above normal. But as noted in the tweet stream, we are converging on what will be a more difficult path to navigate. The Fed made a mistake and overdid the COVID response, and then held it too long. It deserves credit, on the other hand, for pivoting and throwing off the dovish history of the last two decades to begin shrinking the balance sheet and for being steady on that path even as the rate hikes cease. But those were, or should have been, easy decisions from the monetary policy standpoint as the central bank was leaning into the prevailing wind by pursuing restraint when the economy was robust.
Before too long, the Fed is going to face a circumstance where restraint remains necessary because inflation is sticky at too high a level, but longer-term interest rates begin to tick higher. This will put pressure on economic growth, and on the budget deficit, so that their restraint will be seen as wrong-headed. That’s the danger zone, and I think it probably is a 2024 problem. My fear is that it will be very difficult for the Fed to not give in, arguing to itself that “hey, slower growth means lower inflation” even though there’s no evidence for that, outside of energy, and start to temper its hawkish stance.
That would be a big mistake. But it’s probably next year’s mistake. For now, we can sit back and watch the core and median inflation numbers come down. Not as fast as people will be expecting, but the direction is right.
Asset Class Correlations Convict Central Bank Activism
A couple of months ago (Inflation Volatility Tells Us This is Probably Not Over), I argued that one characteristic of higher-inflation environments is that the volatility of inflation numbers is also high. While it does not automatically follow that high inflation volatility implies that inflation itself will remain high, it is suggestive that cries of relief for the end of the inflationary episode might possibly be premature.
Today I expected to make a similar observation about correlations, but as you’ll see my investigations took a different turn. Previously I’ve noted that when inflation rises above roughly 2.5%, stocks and bonds tend to become correlated – which messes up a key part of the value of a 60-40 portfolio. Here’s an updated version of my favorite chart, illustrating that phenomenon. Sure enough, now that inflation has been above 2.5% for 3 years, correlations between stocks and bonds have returned to what they were back when inflation last mattered to investors: the 1965-2000 period. This has happened before, and it really isn’t surprising.
But it’s more than just stocks and bonds. I recently had the opportunity to look at the three-way correlations between stocks, bonds, and commodities. It is very unusual for all three of these correlations to be positive with each other: stocks to bonds, bonds to commodities, and stocks to commodities. Generally, if you average those three correlations you get something positive but right now the rolling 12-month correlations of those three asset classes average nearly 0.8.
In fact, the recent peak in this average of the three correlations (the heavy blue line) is the highest since TIPS were first issued in 1997.
It’s actually a little strange, when you think about it: rising inflation ought to be bad for stocks, and bad for bonds…but good for commodities! But because we are looking at rolling 12-month correlations, it’s actually more about the cointegration of financial markets. Commodities can go up over time, while bonds are going down, and they can still be correlated month-wise as long as the commodities ups are bigger, and the downs smaller, than the bonds ups and downs. (See the following hypothetical example where bonds fall 61% and commodities rise 124% in a year, but they have an 0.91 monthly correlation).
So while the high correlation is not unrelated to being in an inflationary period – after all, unless stocks and bonds are positively correlated you couldn’t get the average to 0.8! – I think it’s more likely to be an indicator of how markets overall are just chips floating about on the tide of the global liquidity cycle as it flows in and out. This hypothesis is reinforced (although it remains a hypothesis!) when we back up even further and look at these correlations going back to the 1960s. To do this, we have to use the Enduring Investments synthetic TIPS return series, which I first wrote about here. When we do this, we find out that three-way correlations haven’t been nearly this high going all the way back to 1960.
The overall level of correlation has been generally rising since…approximately September 2008. Interestingly, that’s approximately when the Federal Reserve first started the waves of QE. Coincidence?
It’s even less ambiguous if you look at rolling 36-month correlations. Since the Global Financial Crisis, the correlations have almost always been higher than the highs from the prior five decades!
It isn’t like we needed more evidence that the Fed’s heavy hand has changed markets. But it is always a good reminder that there is a cost to the endless money fountain. While central bank largesse may undergird returns (at least most of the time), it does so while increasing portfolio risk by increasing asset class correlations. There is no free lunch, indeed, even when it looks like there is.
Home Price Futures Curve Still Looks Weird
As we all know, shelter inflation is very important to the overall rise in the cost of living. Recently, concern about the acceleration in shelter inflation that happened between 2021 and 2023 has been dampened somewhat as the CPI for primary rents and for Owners’ Equivalent Rent have both clearly peaked.
We know that the rent deceleration will slowly unfurl over the next year, and the Fed has recently admitted that this ability to project rent deceleration gives them some comfort on that score. Now, I recently talked in one of my podcasts about why the new models forecasting rent deflation in our relatively-near future should be taken with at least a grain, and probably a shaker, of salt…but that being said, both of our models suggest rent inflation may decline to 3% by the second half of 2024, but is unlikely to drop further than that. Our newer, unique model is driven by modeling landlord costs, and it looks very promising.
Our older model has fared worse, but with good reason. It overestimated rent inflation in late 2020 into 2021, because the eviction moratorium put pressure on rents but did not affect home prices, and then underestimated inflation thereafter partly because rents had to catch up when the moratorium was lifted.
Although the first model above looks to predict much more tightly (although that’s partly because it’s a new model so we are just now generating out-of-sample data to compare with forecasts), the second model is of interest today. That model uses several different measures of home prices and related series, and blends them with different lags to generate the forecast. In other words, this model relies on the behavior of a substitute to rented housing, and that is owned housing. It’s interesting here because it is fairly typical of the way rent inflation has historically been estimated: as (mostly) a lagged function of changes in home prices. If home prices go up, then rents tend to rise because the price of a substitute is rising; if home prices fall, then rents tend to decline because the price of a substitute is falling. Microeconomics 101.
The reason I mention this is because the predictions that rents will be in outright deflation next year are partly driven by the fact that home prices peaked in nominal terms last July, and so year/year home price inflation has declined from about 21% at the peak to slight deflation, in nominal terms, recently (using the S&P Case-Shiller Home Price Index). In real terms, the Case-Shiller HPI dropped about 9% from peak to trough, and around 6% in nominal terms. So, the thought is that the absolute level of rents need to not only level off but actually decline in order to be consistent with what is happening in the housing market. And, of course, people firmly believe that not only do high interest rates cause declines in housing activity but also (despite the lack of evidence) in home prices. I’ve been pointing out for a while that that’s not historically true – home prices in the 1970s never declined in nominal terms y/y and mortgage rates were high and variable.
Well, today the S&P Case-Shiller Home Price Index was released and once again surprised to the upside. In nominal terms, home prices are almost back to the highs although they remain a bit below the highs in real terms.
Now, I showed the SPCS 10-city, rather than the whole index, for a reason. The broader index looks the same, but you can’t trade futures on it. What is really fascinating to me is not just that home prices have rebounded faster than I expected – there really is a shortage of houses out there – but that the futures market is pricing in declines after September and that home prices will not reach a new peak until at least 2027.[1]
Look, I definitely believe that a recession is in store and we may already be feeling some of it although weakness in China could help hold it at bay for a bit longer. But higher interest rates have actually slowed down some of the home building that was addressing the housing shortage; moreover, in an inflationary environment such as the one we are in right now home prices can fall in real terms without falling in nominal terms. That misunderstanding…that ‘bubbly’ home prices would have to be resolved with a steep decline in nominal home prices…is why at one point the Feb 2024 CME Case-Shiller Home Price Futures contract traded as low as 268. That price implied a 19% nominal decline in home prices from the high, on top of inflation running at 3-5% per year, in a housing-shortage environment! As the Case-Shiller numbers have persistently run far ahead of that worse-than-the-global-financial-crisis scenario, the futures have slowly pinched higher. But it is amazing to me that, even has nominal home prices are about to reach new highs, that the market is pricing in a second decline in prices before a weak multi-year recovery!
Futures markets show where risk clears, not where investors think the price will be in the future. So what this is really saying is that people who want to hedge home prices outnumber those who want to buy homes cheaply. And that’s plausible to me. But it still seems amazing! And it also means that the following wind the Fed believes they have from disinflating rents…may not be as strong a following wind as they currently expect.
[1] Disclosure: I run a long-only strategy that passively uses this (fairly illiquid) contract, and so I am always net long. But, for what it’s worth, it actually works against my long-run interest to have the longer contracts trade up to make my future rolls more expensive, so hopefully you’ll all think home prices should be going lower.
Three Pertinent Inflation Observations
I have three items to discuss in this week’s post.
The first item is an announcement made by the BLS on Tuesday regarding upcoming changes to how the CPI for Health Insurance will be computed.
The backdrop for this change is that the CPI for Health Insurance is an imputed cost for the CPI. When a consumer buys health insurance, he/she is actually buying medical care, plus a suite of insurance products related to the actuarial benefits of pooling risks (that is, it’s much cheaper for people to buy a share of an option on the tail experience of a group of people, than it is for each person to buy a tail on their own experience – which is the main benefit/function of insurance). If all of the cost of health insurance was actually for health insurance, the weight of medical care itself (doctors’ services, e.g.) would be quite low because most of us pay for that care through the insurance company.
So the BLS needs to disentangle the cost of the medical care that we are buying indirectly from the cost of the embedded insurance products. The link above goes into more detail on all of this, but the bottom line is that once per year the BLS figures out what consumers paid for health insurance, how much of that was actually used by the insurance company to purchase health care, and therefore how much is attributable to the cost of the insurance product. Because they do this only once per year, and smear the answer over 12 months, you get step-wise discontinuities in the monthly figures. For many years this was not a big problem, but since 2018 there have been several fairly significant swings. The chart below shows the m/m percent change in health insurance CPI. You can see it went from stable, to +1.5% per month or so in 2018-2020, to -1% for 2020-2021, to +2% for 2021-2022, to -4% in the most-recent year.
That latest period has been a significant and measurable drag on the overall and core CPIs, and it was due to reverse starting with the October 2023 CPI released in November. Estimates were that it was going to be something like 2% per month, roughly. The change announced above introduces some smoothing so that these swings should be significantly dampened. The basic method doesn’t change, but it should be smoother and more-timely since the corrections will be every 6 months instead of every year. In order to make the new calculation method match endpoints, though, this means that starting in October, the +2%ish impact will bedoubled because the BLS will make the ‘normal’ adjustment but smear it over 6 months instead of 12, then transition to the new method.
The implication is that Health Insurance, which will have decreased y/y core CPI by about 0.5% once we get to October, will add 0.25% back over the 6 months ending April. So, we already know about a significant swing higher in core inflation that is coming soon. Take note.
The second item I want to note is M2. It’s a minor thing at this point, but after three months it is worth noticing that M2 is no longer declining. It isn’t a lot, as the chart below shows, but the three months ended April showed a contraction at a 9.6% annualized pace and the most-recent three months saw an increase at a 3.7% pace.
In the long run, 3.7% would certainly be acceptable but remember we still have some M2 velocity rebound to complete. What is interesting is that this is happening despite the fact that the Fed is continuing to reduce its balance sheet and loan officers are saying that lending standards are tightening. It may simply be a return to normal lending behaviors, with a gradual increase in loans that naturally accompany the rising working capital needs of a growing economy. Remember, banks are not reserve-constrained at this point, so they’ll keep lending. Anyway, I don’t want to make too much of 3-month change in the M2 trend, just as I was reluctant to make too much of those early M2 contractions…but this is what I expected to happen. I just expected it earlier. We will see if it continues. If it does, then that in concert with the natural rebound in M2 velocity means that further declines in inflation are going to be difficult, and we might even see some reacceleration.
Finally, the third item for today. In my podcast on Tuesday, I asked the question whether China’s recent sluggish growth, caused partly by its property bubble and overextended banks, meant that we should be looking at recession and disinflation in the US – which is the current meme being promulgated by many economists. I discussed the 1997-1998 “Asian Contagion” episode, and explained that a recession in a “producer” (net exporting) country hits the rest of the world very differently from a recession in a “consumer” (net importing) country like the US. A recession in consumer countries causes recession in producer economies, because the consumer economies are ‘downstream.’ On the other hand, a recession in producer countries can have the opposite effect on its customers – because, when an economy like China is in recession, that means it is providing less competition in the commodity markets that we also use. In turn, that means we can actually grow faster, all else equal.
This is what happened in the Asian Contagion episode, and I wanted to put some charts around that. The Thai baht was the first domino, and it collapsed in August 1997. It wasn’t until fears that the Hong Kong Dollar would de-peg from the USD, in October of that year – precipitating a 7% one-day drop in the Dow – that people in the West started getting very concerned and the Fed started citing troubles in the former Asian Tigers as a downside risk. Here are charts of the period. The first one shows quarterly GDP, which never increased less than 3.5% annualized; the second is median CPI, which was continuing a long period of deceleration from the 1980s prior to the crisis…but which began to accelerate in mid-1998.
The bottom line is that as long as our export sector is relatively small and as long we remain a developed consumer economy, weakness in producing economies is not a dampening effect for us but rather, if anything, a stimulating effect.
Summary of My Post-CPI Tweets (July 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup for August (July’s figure).
- At 8:30ET, when the data drops, I will run a bunch of charts. Because Twitter has made auto-posting them difficult /impossible, I’ll post those charts manually with commentary as I go. Then I’ll run some other charts.
- Later, I will post a summary of these tweets at https://inflationguy.blog and then podcast a summary at https://inflationguy.podbean.com. Thanks again for subscribing!
- Get ready: today will be a low number, and good news. But it’s about as good as the news is going to get. Y/y core will decline again next month, but the monthlies won’t keep improving.
- This month, the forecasts get a large drag from Used Cars. And in fact, Used Cars creates downside risk to these numbers – it has surprised significantly on the high side for multiple months. If there’s payback, it could be a LARGE miss.
- The y/y figures for used cars have been in line with y/y figures from Black Book, so it’s possible that the recent misses have just been because of some odd seasonal quirk.
- If so, then no payback is necessary and we’ll get something like -2.5% (my forecast), plus or minus a couple of tenths. (That’s somewhat joking since this series is very volatile).
- I actually wrote a column (on the blog) about the volatility of these various series. While everyone thinks inflation is going to drop swiftly back to earth, the volatility of the numbers hasn’t done so. And that’s a tell.
- This is rolling 12-month volatility on used car CPI. The picture looks similar for lots of subcategories.
- The basic idea is that if everything was returning to normal in terms of the trend inflation level and the placid behavior of it…then we’d also see the VOLATILITY of inflation plunging back to normal. Not yet.
- Looking back at those forecasts, I should point out that I’m again (and annoyingly) right about where the consensus of economists is. Kalshi is lower, though it has been trending higher. Again, I do think there is downside risk to this figure.
- OER and Primary rents I have penciled in at +0.43%, sequentially slower from +0.45% last month. There is further slowdown coming, but we aren’t going to zero as NTRR and other models are predicting.
- I really like our new model, which is not just functionally a lag of property prices (which drives most models) or a straight lag of less-accurate (but current) rent figures. I write about the model in this quarter’s Quarterly Inflation Outlook (due out Monday).
- Because a lot of the drag this month is going to be from Used Cars, and we collectively feel pretty confident about that, it’s going to be critical to look at Median. Last month it was 0.36%, and the last several have been much better than those from the prior year.
- So again, all of this is good news. But we are using up a lot of the good news, and while everyone will extrapolate today’s CPI if it’s good news be careful about that.
- This month will also gets flattered on the headline from declines in piped gas, and the rise in gasoline won’t hit until next month. Oh, and gas is rebounding too.
- In the big picture, ‘supercore’ (core services less rents) is still the main category of interest, knowing though that it’s dampened by Health Insurance.
- Along those lines…the large rise in UPS compensation is emblematic of the new muscle of labor and a reminder that the wage-supercore feedback loop is still operating.
- Again, don’t get too excited by today’s good news! The big picture is: money stock contacting, but money velocity recovering (fastest 3q rise ever). Core goods down and dollar strong.
- But government deficits are rising again, partly because interest costs are skyrocketing. This federal dissaving isn’t seeing offsetting domestic (or international) saving. So expect more pressure on interest rates. And it sets up a future dilemma for the Fed.
- We aren’t out of the woods yet. I think inflation is going to ebb to the high 3s/low 4s on median CPI, but then get pretty sticky. And the next upthrust in inflation will start from a much higher level than before.
- But that’s all far away. In the meantime, inflation markets have been relatively calm with breakevens up a little bit over the last month and real yields hovering just below 2%.
- It would be a great place to have the market find balance, around long-term fair value on real yields. But…inflation volatility suggests it’s far too early to declare victory on inflation for all time.
- Good luck out there!
- OK, 0.167% on core. Numbers still coming in, waiting to see how much was Used Cars. Rents were behaved.
- Sorry, that was 0.160% on core. 0.167% was SA headline.
- Used cars was -1.34% m/m, so about half of what I expected and the general consensus. So what dragged?
- Charts will follow in a few. OER was +0.49%, a bit higher than I expected; Primary rents +0.42%. Lodging Away from Home -0.34%.
- Wow, another huge drop from airfares. Remember last month’s -8.11% drop was almost unprecedented? Well, we got a second month of the same. That seems implausible. Not sure what’s happening there!
- Core goods, thanks to Used Cars mainly, dropped to +0.80% y/y. Core services is still high, but fell from +6.2% to +6.1% y/y.
- The diffusion things will look interesting. Of the 8 major subcategories, Housing was +0.35% m/m but no other category was higher than +0.23% m/m (and that was food). Next highest was recreation at +0.12%.
- Not my normal first chart but here is y/y CPI for pharma. It was +0.58% m/m.
- OK folks – here’s m/m core CPI. As I said, don’t get used to this low level. But it sure LOOKS like we’ve gone back exactly to 2% and stuck the landing!
- Here are the 8 major subgroups I mentioned. Very tame m/m.
- Now THIS is the big chart. This is Median CPI. I want to look at the subcomponents – Other Food at Home was the median category. This is the best news in the report.
- Here is the rent chart. Our model has them going to ~3% over the next year. Unless core goods keeps dropping (which means the dollar continues to rally) it’ll be hard to get inflation back to 2% if housing is at 3%. Only reason it happened before was core goods deflation.
- To that point, core goods needs to go negative if you want to get back to 2%. And I think even then it’s difficult unless wages crash back down. No sign of that at the moment.
- Four pieces. The interesting bit is that core services ex-rents actually rose slightly y/y.
- More on Median. It clocks in at +0.19%. Amazingly, that’s despite all of the OER subcomponents being higher than that. Usually to get a low number you need at least one of the big-weight pieces to be there.
- But in this case, we had Recreation, Medical Care Services, New Vehicles, Housing Furnishings and Operations, all 4% or higher weights and all less than 1.5% annualized m/m.
- That starts to look a little quirky. If even one of the 1% categories had been higher then the median category would have been Fresh Fruits and Vegetables and the m/m would have been 0.29%. Still low but not the number we will see.
- I’ll have the diffusion charts in a minute and those are interesting. So, low core and median – you’d think a lot of really low categories right? But only ones below -10% annualized were Public Transportation (-54%, flag that!), Used Cars/Trucks (-15%), and Misc Pers Goods (-11%)
- On the high side we had Motor Vehicle Maint/Repair (+13%), Infants’/Toddlers’ Apparel (+17%), Motor Vehicle Insurance (+27%), plus a couple of non-core categories.
- But there were a LOT between -10% and +1.4% annualized.
- Core ex-shelter fell to 2.62% from 2.80%. It was lower in early 2021 but this is improvement obviously.
- as I said the airfares piece is really odd. Never have had 2 back to back months like that EXCEPT at start of pandemic and that was with jet fuel prices plunging. They’re not. This is…hard to believe. It’s a one-off last month I said we could be sure we wouldn’t get again! [First chart is m/m, second is y/y.]
- You really can go either way on this number. Here is the Enduring Investments Inflation Diffusion Index. The disinflation is continuing, and that’s good news. OTOH, we have some really crazy outliers like airfares.
- Here’s where CPI Airfare sits relative to jet fuel (seasonally adjusted). We are likely to see a catch-up in this next month. I am really curious which routes are getting lots cheaper. I haven’t seen it.
- Now, maybe airfares is a micro effect here that indicates a softening in travel and an early warning of decreased consumer spending. Maybe it’s a bullwhip – after “revenge travel” everyone is going back to normal travel demand. Still, betcha we don’t get another -8% next month.
- OK last chart. This is y/y but it looks similar m/m. The high bars on the right are shelter and they’re moving left. Few huge outliers on the right. Then lots of little categories strung out between 3 and 7%. Then about 22% less than 2% including 17% in outright deflation.
- The outright deflation ones are mostly core goods, and they’re not generally going to stay there. So what we are going to see over next year is all of these things starting to trend back towards the middle. Where’s the middle? I think it’s high 3s, low 4s. But that’s the question.
- Bottom line here. Overall number pretty close to expectations. There is nothing here that would argue that the Fed ought to keep raising rates – inflation is drifting lower, and nothing they can do will speed that up.
- Indeed, nothing the Fed has done so far has caused this, except inasmuch as higher rates helps the dollar which helps core goods to decline. Now…the Fed also oughtn’t ease any time soon. There’s no sign of deflation here or even stable sub-2% inflation.
- Ergo, I think we are going to see the Fed basically go to sleep here for a while, unless the bond market starts to get sloppy because of the huge demand from Treasury. If the Fed needs to intervene and buy bonds…that will be a very bad sign. But not going to happen today!
- Thanks for tuning in.
We knew going in that this would be a soft number, and that it also would likely be the softest in a while. We didn’t get as much of a drag from used cars as we expected, but we got some; the real culprit was the large drag from airfares. It’s hard to understand that one, but especially with jet fuel prices back on the rise we are going to get a give-back from that next month in all likelihood. Indeed, the August CPI is shaping up to be sobering. Core should be above 0.3% m/m again, and headline is currently tracking at 0.65% or so on a seasonally-adjusted basis. So store the party hats for now.
That said, it was encouraging to see so many categories with small changes on the month. There were enough changes that median inflation is going to print very low, 0.19% or so, this month. If that were to recur it would be a great sign. Alas, it’s very unlikely that we will see another median like that very soon. As it was, it was almost an 0.29% as the next category above the median one was that much stronger.
From a market perspective, this is positive. That’s partly because “the market” tends not to look ahead very much (yeah, I know you learned something different in school but “the market,” especially in a day dominated by mechanical trading based on parsing the news headlines, does not discount the future very well any more. That’s one reason why we keep having periodic mini crashes when reality abruptly intrudes). This inflation number gives no real reason for the Fed to hike rates again. As it was, the argument for another 25bps after 500bps have been done was always very weak, especially since there is no real evidence that interest rate hikes do very much to inflation. At some point, the beatings get to be gratuitous and sadistic.
The problem is that there is going to be pressure on longer-term interest rates given what’s happening with the budget. I’m watching that carefully. As I write this, 10-year interest rates are back above 4%. With data like this, that doesn’t make a lot of sense. But there’s a lot of paper out there and it may need higher rates to find its “forever home.”
So, enjoy this print. It’s legitimately positive news. Only the folks looking ahead to next month ought to be less cheerful but in the meantime eat, drink, be merry, and buy stonks.*
* This is tongue-in-cheek naturally.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
How the Fed Saved Structured Note Issuance
There’s an aspect of the higher interest rate structure we are now blessed/cursed with that hasn’t gotten as much airplay, but which is great news for dealer desks and also a good thing for institutional investors (and some high net worth individual investors). And that is the new energy that the higher rates will inject into private note structured product.
A classic structured note is typically designed so that the buyer is guaranteed to get his money back, plus the possibility of some more-attractive payout. So, for example: I might issue a note that will pay you 60% of the total gain in the S&P 500 over the next 5 years – but if the S&P is lower in 5 years, you still get your money back. That’s a pretty simple version, but the embedded bet can be as exotic as you like (and from the standpoint of the dealer, the more exotic the better because the harder it will be for you to price it and the more profit, therefore, they can book on it).
When I was tasked with issuing notes from the Natixis Securities (North America) shelf, for example, we offered a 10-year note that redeemed at either the total rise in the CPI over those 10 years, or the average return of the S&P, Nikkei, and EuroStoxx 50, or par (100%), if both of the other two possibilities were negative. I recall another dealer in 2007 or 2008 was selling a 1-year note that had a huge coupon as long as inflation was between, say, -1% and +3%, but zero otherwise. But you still got your money back. You could structure something with knock-out options, average-price or best-of or lookback options – on interest rates, equities, commodities…even an option on a hedge fund. I want 20% of the latest global macro fund’s upside, but with guaranteed downside…
The key ingredient to all of these things, though, is interest rates – and when interest rates are very low, it is difficult to make a structured note look attractive.
Once upon a time, like back at Bankers Trust in the mid 1990s, the way a structured note was created was to make a special purpose trust that held two securities: a zero-coupon Treasury bond with a maturity equal to the note’s maturity, and ‘something else’ – usually an option. The investor would invest $100. The dealer would spend $80 on the zero coupon bond…which, since it matures at par, guarantees the principal…and have $20 left over to spend on anything else that couldn’t decline below zero. Classically, this is an option, so the trust would look like this:
Since the option can’t be worth less than zero at maturity, and the STRIPS is guaranteed to be worth $100 at maturity, this bond is principal-guaranteed by construction and has no credit risk. Any value the option has at the end of the term is an add-on. If the option is worthless, then the bond matures at par. So simple.[1]
You can see why interest rates matter. This 5-year zero-coupon bond at $80 implies that it is priced at a compounded interest rate of 4.56% (because $80 * (1+4.56%)^5 = $100). But suppose that 5 year interest rates are 0.75%, as they were two years ago at this time? Then the 5-year coupon bond will be priced at 96.33, and instead of having $20 to spend on options the structurer will have less than $4. There aren’t a lot of options priced at $4 that will be exciting enough to an investor (or have enough spread to be exciting enough to a dealer). Never mind the fact that in all of this I have neglected that a dealer generally also gets paid to underwrite and distribute the bond, so that $1 or $2 will come off the top. In this last example, the dealer doesn’t have $3.67 to spend on options…it probably has only $2. Good luck.
I present the notion behind structured product that way because it’s easy to conceptualize and because that’s the way the concept started, but it has been a long time since dealers actually used zero-coupon Treasuries in such a structure. The way such a note is made today is driven by the credit of the issuer, so the structured note trust really holds an IOU from the borrower. In most cases, this is the dealer itself but there are other companies who will issue in their name in order to get bargain financing rates (once the dealer hedges away all of their risk). The mechanics are not worth going into here: if you are someone who would care, you probably already know how to do it, and most of you won’t care. The significance is that the structurer can get a little more spread to play with, since the interest rate will be a corporate credit rather than a government bond. But still not lots.
However, now interest rates are back up. Two-year Treasuries are at 4.90%, 3-years are at 4.50% and 5-years are at 4%. That’s back to the way it used to be. Even real rates are meaningfully positive. And implied volatilities are generally low as well. All in all, structuring desks doubtless have a lot more to do these days than just a few years ago. Not everyone hates higher rates!
[1] Since this column generally concerns itself with inflation and real variables I should point out that you can also guarantee par in real terms, by substituting a TIPS STRIP or the derivative equivalent, so that the investor will get at least the inflation-adjusted amount of his money back rather than the nominal amount; however, then the structurer will have less premium to play with.
Inflation Volatility Tells Us This is Probably Not Over
In the course of this inflation cycle – and I do think this is a cycle, and not necessarily a one-off, although the subsequent peaks may not surpass this year’s peak in Median CPI for some years – the typical topic has of course been the level of inflation, and/or its acceleration or deceleration (not to mention, many uneducated suppositions about the cause, which we know good and well boils down to profligate spending and unprecedented provision of money). I’ve also written and talked about the oft-overlooked fact that when inflation rises for some time above about 2.5%-3%, stocks and bonds become correlated rather than inversely correlated, and this has a significant effect on portfolio risk that insightful investment managers will take into account.
What I haven’t written about much is the fact that problems are also caused by the volatility of inflation. While this tends to go hand-in-hand with higher inflation, the problems caused by inflation’s volatility are somewhat different than those caused by its level.
The current episode follows a 15-year period during which inflation was both low and stable. The thirty years prior to that, from 1973-2003, the level of inflation was a bit more than twice the 2004-2018 period average but the volatility of inflation was tripled.
The importance of inflation volatility is that it operates on inflation expectations in a very different way than the inflation level does. (We know that inflation expectations do not have the center-stage role in ‘anchoring inflation’ that previously-discredited theory claimed it did, but I do think there is a psychological tendency that adds some inertia to inflation by affecting businesses’ beliefs about how easy it will be to increase prices.) Inflation volatility tends to increase consumers’ perceptions of inflation through the behavioral tendencies towards loss aversion and attribution bias (as I argued in a 2012 paper published in Business Economics). But it has other effects as well.
Quantitatively, higher variance makes it harder to reject the null hypothesis that inflation is staying high; an uncertain worker is therefore less likely to accept a lower wage that may not suffice and a business is less likely to hold the line on prices that may be continuing to rise elsewhere. When you don’t know the true competitive pricing situation, both businesses and their employees are likely to err on the conservative side. This also gives momentum to inflation.
Higher inflation volatility is what causes the inflation factor to carry more weight in the minds of consumers and investors, which in turn is what induces the aforementioned positive correlation between stocks and bonds. When inflation is low (but more importantly stable), the importance of inflation to investors is also low and variations in inflation are given less weight than variations in growth. Since stocks and bonds behave similarly with respect to inflation, but inversely with respect to economic growth, the dampening of the inflation factor is the reason that stocks and bonds are inversely-correlated in low-and-stable inflation regimes.
Also, although investors seem not to incorporate this understanding into prices, higher inflation volatility should increase the value of a “tail outcome” in inflation, and increase the value of holding that option by being long breakevens, or long TIPS instead of nominal bonds. That is, when inflation isn’t going to vary too much then it’s hard to win big by owning TIPS over nominals; but if inflation varies a lot then there should be a fairly large premium built into breakevens since you’d much rather be long them (and long that tail) than short them (and short the tail). However, as I said this seems not to actually be incorporated in inflation markets, which trade far below the level they ought to if inflation tails have even a small value.
So, how volatile has inflation been?
When I started thinking about this blog post I was originally going to point out that the volatility of Used Car CPI is so much higher than it used to be. We almost never spent a lot of time thinking about how much Used Cars would add or subtract from core. Here is a chart of the rolling 12-month volatility of y/y Used Cars CPI.
Not surprisingly, the volatility of CPI for Used Cars and Trucks reached nearly double the level it did in the aftermath of the Global Financial Crisis, when the “cash for clunkers” program and the destruction wrought by Hurricane Katrina both had major impacts on the market for used cars. But it goes beyond that.
The unusual volatility of the food and beverages group, partly as a result of the war in Ukraine and the spikes in fertilizer prices, has been documented previously. It seems to be receding but remains quite high historically.
Heck, let’s look at three of my ‘Four Pieces’ (leaving aside energy). Here’s Core Goods.
Even though the level of core goods inflation has come way back down, the volatility of core goods means that consumers can’t get terribly comfortable with prices (nor can producers).
How about ‘supercore’?
This is also high, but the interesting part is how tame it had been for most of the post-GFC period. Remembering that this is the category where the wage-price feedback loop is felt most strongly, I think this says something about the flaccidity of labor power during that decade. Well, that’s back – and perhaps we’ve re-entered an extended period of volatility in that group?
Here is the volatility of Owners’ Equivalent Rent (which looks about the same as Primary Rents, for what it’s worth, so I didn’t feel I needed to show them both).
Not as terrible as I would have thought, although to be fair this is typically a less-volatile category anyway. Again, though, look at the amazingly boring period post-GFC. (As an aside, that’s when a certain inflation specialist was trying to get attention for Enduring Investments.)
In a second I’ll show all-items CPI, but first let’s look at Medical Care.
This is the only category of the ones I’ve shown where volatility is still increasing. That’s largely because of Health Insurance, which as I’ve documented/complained about for some time has endured one of the most massive swings in any imputed category. That will not plummet soon, though, since in October the Health Insurance drag of -4% or so annualized will reverse to +1% or so.
Last but not least, here is headline CPI’s volatility.
I will just say that it is a good thing that inflation dealers no longer really trade inflation options. Because, if they did, they not only would be generally short a whole lot of in-the-money inflation cap delta in the book but also would be short a bunch of vega too and implied vol would probably be a lot higher. But the importance of this picture is that while headline inflation has been receding (largely due to energy) and core inflation has been dropping too (not-insignificantly due to Health Insurance and Used Cars), the volatility of inflation does not yet look like it’s calming down in a decisive way.
Until it does, I think it would be cavalier to assume that we are heading back to the low-and-stable inflation regime, even if the last few months’ out-turns for CPI have been agreeable. Volatility, and not just the level of inflation, matters.
Summary of My Post-CPI Tweets (June 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but subscribers to @InflGuyPlus get the tweets in real time and a conference call wrapping it all up by about the time the stock market opens. Subscribe by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup for July (June’s figure).
- At 8:30ET, when the data drops, I will run a bunch of charts. Because Twitter has made auto-posting them difficult (still not sure it’s impossible), I’ll post those charts manually with commentary as I go. Then I’ll run some other charts.
- After I’m tweeted out, I’ll have a conference call with my overall thoughts. This is usually around 9:30ish. Later, I will post a summary of these tweets at https://inflationguy.blog and then podcast a summary at inflationguy.podbean.com .
- Thanks again for subscribing!
- The forecasts this month are almost comically low. Keeping in mind that last month, core came in high at 0.44%, and hasn’t been close to 0.3% since October – my forecast is the highest except for Cleveland Fed.
- The first forecasts out of major banks were low even though they had a bump higher from Used Cars. Such a bump seems unlikely, although last month I thought would drag and it did not. But the surveys are worse this month.
- Later bank estimates penciled in declines in Used Cars that make more sense. For a while I thought I was doing something wrong.
- I’m not TOTALLY sure Used Cars will be a LARGE drag. Black Book declined in June, but it also did LAST June, and the Used Cars CPI rose. So there may be a seasonal glitch here that’s not being picked up (or is over compensated for).
- My arms-length calculation suggests an 8bp drag from a -2.4% decline in used car CPI, but I will not be surprised if it’s unchanged. I WILL be surprised at an increase.
- On the other hand, used car CPI has been running ahead of Black Book for a couple of months so perhaps that effect already happened. Thus in classic economist fashion I split the difference and penciled in a 1.2% decline, a 4bp drag on core.
- As you can see from this chart, once you make a minor volatility adjustment Black Book is a VERY good forecast of y/y used car CPI. There is volatility in the month/month (some due to seasonals) but it’s heroic to forecast a large miss.
- Now, aside from Used Cars there must be other drags to give us the lowest core CPI in a long time. The large banks are looking for another decline in airfares and a retracement of the strength in lodging away from home.
- (To be clear, I don’t usually spend much time looking at other forecasts until after I’m done with mine. But I peeked more this month because of the really low forecasts coming out).
- Basically, the Covid categories, along with a sequential additional slowing in rents. I have rents a trifle softer too, but not a ton.
- Traders on Kalshi though MUST have big declines in rents penciled in. The Kalshi forecast for core is among the lowest out there, AND it has been really steady. Decent volumes (compared to history) too. Never say never.
- I think part of what is going on is that summer seasonals drag a lot from the NSA figure. By forecasting low month/month numbers, economists are basically saying the trends haven’t picked up like in a normal summer.
- I am not so sure of that. A lot of those are broad trends, not just in Lodging Away from Home or rents. But I think that’s the source of some of these soft forecasts, implicitly.
- A quick look at the month’s trading leading up to this. Pretty stable overall. Yields are significantly higher, but not in a sloppy way, and breakevens/CPI swaps only marginally wider. Slow summer trading for the most part it seems!
- One final note here. I said last month that we want to see the numbers not only head lower but also BROADLY lower, not just pulled lower by a few outliers. That means rents, it means services ex-rents. Not just health care services, not just Used Cars.
- So we will look beyond the headline for that. Good luck!
- Kalshi ftw I guess! 0.158% on Core and 0.180% on headline.
- First glance, I see -8.11% on Airfares and -2.01% on Lodging AFH. I still don’t see any airfares declining but they have been for several months. This is a BIG one.
- This clearly looks like a trend change, but I’d be a little careful.
- Decline in Education/Communication. Everything else positive but very tame.
- Core goods (+1.3% y/y) went back down, although I suspect that’s mostly base effects. Core Services turning down more in earnest (+6.2%). But again…
- OER and Primary rents have clearly peaked, but no surprise there. OER was +0.45% m/m, down sequentially from +0.52% last month; Primary rents were +0.46%, down from +0.49%. No collapse here.
- So this tells the story better. My estimate of Median is 0.365% m/m. Still better! But not the collapse that core is suggesting. Which tells you the core drop is a tail thing.
- Sorry, make my estimate 0.359%. Energy Services looks like the median category.
- So the “COVID Categories” are where the intrigue is. Airfares as I said, -8.1% m/m. Lodging Away from Home -2.01% m/m. Used Cars was -0.45%, not as low as I’d expected but not an add. Motor Vehicle Insurance was +1.41% m/m…and probably will continue to be. New cars -0.03% m/m.
- Car/Truck Rental -1.43% m/m. Baby Food -1.29%. Health Insurance the usual (for this year; reversing some next year) -3.61% m/m. College tuition is interesting, flat on the month.
- But look: Food Away from Home: +0.38% m/m. Remember, that’s wage-sensitive. So let’s look at the four pieces and see what is happening to core services ex rents.
- Before we do though, here is a chart of (NSA) Airfares. According to the BLS, airfares are back down to where they were pre-Covid. I do not understand that one.
- Piece 1: Food and Energy. Declining on a y/y basis. Now, Food overall was up this month, so was energy, but less than the normal seasonals would suggest and less than last year.
- This was always going to happen – food and energy mean-revert. It was only a surprise in how long it took.
- Core goods, shown before. This is partly due to better supply chains but also partly due to dollar strength. The question is whether it goes back to 0% or slightly negative. I think that’s unlikely, and it matters for whether inflation ultimately settles back where it started.
- Core Services less Rent of Shelter – this looks great! The usual reminder that some of it is a function of the Health Insurance drag that will stop in a few months, and eventually reverse. This will make the Fed feel better though. Yeah, it’s probably not as good as it looks.
- And piece 4, Rent of Shelter. Still way up there, but hooking lower. Is it going to 3% like some forecast? No.
- Core ex-housing dropped to 2.80% y/y, the lowest since March 2021. Part and parcel of the overall nice tone to these numbers. But a lot of them still trace back to a few things, which we’ll see when we look at the distributions.
- This chart won’t change your life but I just want to update it with today’s numbers. Again I wonder what the people calling for an uptick in Used Car prices were looking at. Very modelable.
- Don’t think I said that my estimate of y/y Median is 6.45%, down from 6.74% last month and 7.20% in February.
- Biggest declines (annualized m/m): Public Transport -57%, Lodging Away from Home -22%, Car/Truck Rental -16%. See any outliers? Biggest increases: Motor Vehicle Insurance +22%, Motor Vehicle Maintenance/Repair +17%. Striking the low and high outliers sort of balance except…
- And yeah, most of “Public Transportation” is Airline Fares. Other intercity transportation and Intracity transportation are small weights (and both positive m/m btw). The NSA decline in Airline fares was -6.5%. So not a seasonal glitch: airline fares are plunging. (?)
- Just speculating…there’s been a lot of talk about the improved fuel efficiency so passenger miles are running far ahead of jet fuel demand. So maybe some of this is passing the increased efficiency on to customers (through competition, not benevolence).
- Congrats to anyone who saw that coming to that degree.
- Getting into some of the diffusion stuff. This is the Enduring Investments Inflation Diffusion Index. Dropping all the way to 12 this month. Very good news.
- So gasoline and public transportation go into the mental model of the consumer as one chip each, even though the average consumer buys FAR more gasoline than public transport. But those chips in “transportation” aren’t the same as those in “the food aisle.”
- Anyway that’s the short version.
- Just saw Wireless Telephone Services was -1.46% m/m NSA. That’s odd – ever since data became basically free, the steady deterioration in wireless telephony costs has stopped. This won’t be repeated. The category is 1.8% of core so that’s 2.6bps of drag.
- Last chart. You can see that there is a big weight in 2%-and-under items, a secondary distribution/smattering around 5ish, the two big spikes for shelter, and some far-right-tail items. This is an unclear picture.The far-left items are mostly goods, and the rest mostly services.
- We can all “know” that the airfares and wireless stuff won’t be repeated, and recognize that wage growth is still high (6% on the Wage Growth Tracker) so the important wood is yet to chop. But shelter is in slow retreat, and overall trends look good.
- The data is not exacting any price for a Fed pause. And indeed, hiking into this presents the risk of looking like too much, later. I think the odds of a Fed hike just dropped a lot (I never thought the argument in favor of one was very good, though).
- OK, let’s do a conference call in 5 minutes, at 9:45ET. Call in if you want! [REDACTED] Access Code [REDACTED]
There is no doubting that this was a good number for the market, for the Fed, and for consumers. Yes, core inflation is still 4.8% y/y and Median is still well above 6%. But they’re declining, and that decline will continue.
It’s important to recognize, though, that there has been little debate that there is a deceleration coming in the y/y, partly because of base effects but partly because the Fed has stopped squirting liquidity everywhere. The question is whether inflation is headed back to 2% any time soon. Note that core goods is still well above zero, even with a very strong dollar. If Core Goods doesn’t get negative, there’s not much chance at getting core inflation back to 2% (and note that home prices are rising again, which puts paid to the argument that rents are going to imminently collapse because home prices are going to decline).
What we didn’t see in this figure was the broad deceleration that we really need to see. It is broadening, I suppose, which is why median CPI is slowly declining. We saw huge drops in a few categories that won’t be repeated. Airfares. Cell phones. What we didn’t see were huge jumps in any categories, and that’s encouraging.
The most interesting (and non-repeatable) part of the CPI data was airfares, which was a 5bp drag on core CPI. Amazingly airfares in the CPI are back to the level (not inflation rate, but the price level) seen prior to COVID. Part is lower jet fuel prices, as the regression above showed. But there’s more to it.
I find it plausible that some of the decline in airfares is due to less fuel intensity: more passenger miles with less jet fuel, which is a trend we’ve seen in the weekly energy data. But…have you really seen air fares going down? I haven’t. But I wouldn’t discard this data or expect it to reverse on that basis. Here’s one possible explanation, which is potentially a good reminder not to rely too much on anecdotal evidence without remembering to put the accent on “anecdotal” more than “evidence”: I don’t fly business class, and I don’t buy business tickets. If I were an airline, that’s where I’d be cutting prices – for the non-leisure traveler. Business travel is down, for sure, and is far more discretionary than it used to be. So if you cut the price to the business traveler, overall fares can decline…even if you and I aren’t seeing them. By the way, that’s not the BLS explanation but my supposition.
We need to remember that prior to this figure, there was strong stasis at about 0.4% for core CPI. It’s difficult for me to believe that we jumped from ~5% annualized to ~2% annualized on core, without a stop in between. That being said…this sort of number is great for stocks, and great for bonds, compared to just about any other print. I don’t necessarily think it’s a sign of a sea change, because the big slow-moving parts of CPI aren’t decelerating very quickly. But I can understand the enthusiasm in the markets among those who ignore value and ‘just trade the number’.
This figure also puts the Fed in a bind…or it would, if you really believe the Fed earnestly wants to yank rates up another 50-100bps. I don’t believe that, and think the Fed speakers are mostly burnishing their hawkish credentials to keep markets from getting ahead of themselves. Indeed, they might speak more hawkishly after this, making clear that further hikes are still on the table even though the odds of taking a pass this month just went up a lot.
So enjoy the number! But don’t necessarily get used to it. (That said…Kalshi traders right now have Core CPI for next month at 0.16% m/m. And they were right this month! But repeating this figure without airfares and cell phones will be a serious trick.)
