Inflation Guy’s CPI Summary (February 2025)
Look, I know that traders sometimes think their job is to overreact. And media folks benefit from overreacting. And political strategists have been genetically bred to overreacting. But a bit of rational analysis here is probably worthwhile.
The obvious backdrop to the CPI release this morning is the somewhat-greater-than-usual volatility in the equity market,[1] and some concerns that the economy might finally get that recession that I and others have been expecting for so long – although don’t get too chippy on that, since the Q1 contraction would be mostly due to a surge in imports from front-running tariffs. The narrative has shifted back to the question of how soon the Fed might ease, even if inflation is still a little problem, since Unemployment has risen to the nosebleed level of 4.1% and stocks are in the crapper (technical term).
Geez folks, take a chill pill.
Similarly, don’t cue the trumpets just yet on inflation. The expectations coming into today’s figure were for +0.31% on headline CPI and +0.30% on core CPI. The actual prints were +0.22% and a delightful +0.23% on Core.
Sure, the chart shows this is definitely better than last month! And it’s even better than the average of the last two months (I’d said last month you probably should average between December and January figures). But…it’s also a little early to take a victory lap. Here is Median CPI (last point, as usual, is my estimate for today).
If it’s 0.29% m/m, as per my estimate, then we are at a 3.5% run rate. And that’s basically where we have been over the last six months. Oh, and while y/y Core CPI is down to 3.1%, it’s at 3.5% over the last three and the last six months. We are settling in at the mid-3s.
The culprits behind last month’s spike were used cars, health insurance, lodging away from home, pharmaceuticals, and hospital services. Of those, only Used Cars (+0.88% m/m) contributed very much to this month’s number. On the other hand, Airfares dropped -4% m/m. Here are the Major-8 categories.
The optimistic view is that there isn’t any one category that looks out of control on a y/y basis. That’s also the pessimistic view, because it speaks of a broad – if not particularly high – inflation that is still percolating out there. Core Goods this month was still -0.1% y/y, but Core Services dropped from 4.3% to 4.1% y/y. Pharmaceutical prices, which just had their largest monthly rise in history last month as drugmakers tried to get their licks in before the Trump Administration forces them to lower prices, rose only +0.18% m/m this month. Both Primary Rents and Owners’ Equivalent Rent were +0.281% m/m. These are also settling in, on schedule.
“Settling in” is what is happening in shelter. And that again is both good news and bad news. A lot of the forecasts we have seen over the last couple of years that called for inflation to steadily return to trend depended on the assumption that the rent declines we have seen for new rents in a few cities would become a broad-based trend in all of shelter. But it’s not, for two reasons. On the rental side, costs keep rising for landlords (that’s the basis for our model in the prior chart). And on the home purchase side, there’s just still a big deficit in homes available for sale.
While that could change – it seems to be changing in the Washington, DC area but the people leaving Washington still need homes elsewhere – if deportations pick up a lot, there is no sign yet that shelter is going to do the heavy lifting of getting inflation back to 2%. Neither is SuperCore, although this month it was +0.22% m/m and in general is looking a little better.
But none of this looks exciting. None of this looks like it’s going to be the start of a Fed victory lap on inflation. Even the Enduring Investments Inflation Diffusion Index looks like it’s settling in, and like all of the other stuff we have looked at, it’s settling in at a level higher than pre-COVID.
And while we’re talking about distributions, here’s another one I haven’t run in a while. This is the distribution of y/y changes by the lowest-level CPI components. The big spike in the middle is obviously housing. There is a cluster between 1% and 4%. But look at that big left tail. 20% of the basket is actually deflating, y/y.
What’s interesting about that column on the left is that it is a whole bunch of little things. Breakfast cereal. Pasta. “Other meats” (shudder). Potatoes. Tomatoes. Soups. Snacks. Window coverings. Dishes. Men’s shirts. Audio equipment. In other words, a whole lot of things that are so small, consumers don’t really notice them so much and so they don’t really affect their sense of inflation being high. But they notice eggs.
So this is good news…in that a lot of things are deflating…but also bad news is that a lot of these are things that tend to mean-revert. You’ll notice that some of the categories I just listed are core goods, which are still in deflation…but which are also the things which are going to rise in price when the tariffs start to hit. The largest single piece still in deflation is New Cars, at a 4.4% weight or so. Unfortunately, that’s not going to be in deflation when tariffs hit auto parts and slow the import of non-US vehicles.
So let’s wrap this up.
The conspiracy nuts will say that Trump cooked the numbers, because it was better-than-expected about something that was a campaign promise of his. But this is normal variation, and the bottom line is that the inflation figures look to be converging on 3.5% or so, before the effects of tariffs kick in. The near-term effects on inflation are definitely upwards. Peace in Israel and Ukraine, if it comes, may put a small damper on energy prices but the bigger effect there is US energy being unleashed again, which will take some time. But outside of the peace effect, there are few good near-term trends but also few really bad near-term trends other than the (relatively small) effect of tariffs. Inflation is settling in.
The funny thing is, I don’t think the Fed cares. I think they’re satisfied enough with the progress on inflation, and they still think that recessions cause disinflation (they don’t) so that they feel they can focus on the growth part of the mandate, for now.
[1] Dubbed a ‘crash’, or ‘freefall’, or some other appellation by observers who can’t remember the last time we saw a 10% pullback. Which is only about 6% if you look at the equal-weight, or a 60-40 blend of stocks and bonds. If this warrants the “what do you say to Americans who now can’t retire because they’re seeing their retirement accounts collapsing” line, my answer would be “I would say those Americans probably shouldn’t have been invested in stocks at all if this causes them to delay retirement.”
Gold Prices Are Getting Frothy
Behold, my roughly-annual blog post on gold.
I recognize that there is a good case for gold at a time when the price level is rising steadily and there are upside risks to inflation and downside risks to the dollar. Let me start there.
I get a little confused trying to decide whether, if we find out that Fort Knox doesn’t have as much gold as we thought, that’s bullish or bearish. I think the consensus is that is bullish because it means there’s one less holder that could potentially sell into the market…but doesn’t that mean there is more actual floating supply? Because that gold is out there somewhere. Anyway, that is all idle speculation anyway until we find out whether the unaudited stockpiles at Fort Knox are intact. (As an aside, the whole monetary history of why there are gold stockpiles at Fort Knox or the New York Federal Reserve is fascinating. I just finished reading Lords of Finance: The Bankers Who Broke the World, which is a little unfair of a title but really interesting.)
But the $2,910 question is whether the case for gold at the current price is good or not. Okay, let’s be real – if people still believed that the current price mattered for future returns then most of the Magnificent 7 stocks wouldn’t be where they are…most of the rest of the equity market, probably too. Certainly bitcoin. For today, though, let’s pretend that trees don’t grow to the sky and that your future returns depend at least a little bit on the price you buy at relative to the future price you will sell at.[1]
Erb and Harvey wrote a paper in 2013 called “The Golden Dilemma” which had a wonderful chart in it (Exhibit 5) that showed the annualized 10-year real gold return versus the starting real price. The key insight is the translation to real values. Because the gold nominal price does, in fact, rise with the price level over time to reflect the diminishing value of the dollar. But whether it is likely to rise faster than the price level, or slower, or even decline over some period of time is obviously really important to the question of whether gold right now is a good inflation-hedging asset.[2] The chart below shows the Erb and Harvey chart, updated to today and with a more meaningful x axis priced in terms of the starting real price. The vertical line is the current gold price. All other gold prices are converted to their values in terms of today’s price level, and then the return calculated over the subsequent ten years.
The chart highlights that when the gold price is high in a real sense…when it has outrun inflation for a while…it is likely to underperform inflation going forward. When it has lagged inflation for a while it is likely to outperform inflation going forward. There is a fork on the chart of two different periods, the first being the gold prices when we used to care about value more (the lower fork, where the lowest point is January 1980), and the second being the more recent period where value mattered, but less so. The most-recent point for which we can calculate the 10-year real return is January 2015 when the nominal price of gold was $1278 but in terms of today’s dollars it was $1738 because we’ve had 36% inflation since then. Either way, the current price of gold would suggest that while the nominal price may rise over the next decade, that’s likely only to be the case if the price level rises more (that is, negative real returns for gold). That says that while gold is probably a better investment right now that equities – which have deeply negative expected real returns from the current price – it’s not likely to be as good an inflation hedge as, say, 10-year TIPS at 2% real yields.
Now, I have to address one possibility. There are nuts out there who will say “the fork here is evidence that the changes made to CPI caused it to understate inflation by 2% per year – gold, relative to the price level, is suddenly doing 2-5% per year better than it would historically have done.” It is crazy talk, but given the chart it is due a reply. There are two parts of the refutation. The first part is that the bottom fork doesn’t end in 1980; in fact that was the only fork evident in the Erb and Harvey 2013 piece. If CPI was monkeyed with in a serious way as the conspiracy nuts claim, it happened in the early 1980s. Maybe no one figured it out for a quarter century. I think a better argument is that the first gold ETF, GLD, launched in 2004. The abrupt ease in the difficulty of owning and holding gold almost certainly led to an increase in the allocation to gold in global investment portfolios. If that’s the cause, then the happy fork in this card should be the aberration and we should start to converge on the lower fork over time once that change in the acceptance of gold as a portfolio allocation has been fully realized.
The second part of my refutation is to point to another way that it looks like gold might be a bit frothy. People have pointed to the divergence of gold from TIPS (including me, back in 2024), since gold tends to behave like a long-term zero-coupon inflation-linked bond – in other words, it has a lot of real duration, but for some reason not recently. But showing the deviation of TIPS from gold could mean that gold is expensive or that TIPS became cheap. Look instead at the following chart, which relates two zero-coupon real assets: owned homes, and gold. The line is the price of gold divided by the Existing Home Sales Median Sale Price in thousands (so, one ounce of gold will currently buy 0.726% of a median home right now or, conversely, you need about 138oz of gold to buy the median existing home.
The chart shows three distinct extremes prior to the current rise. The peak in 1980 and the trough in the early 2000s are both obviously gold phenomena. The spike in 2010-2012 is a consequence of the housing bust after the GFC, when home prices drastically overcorrected to clear the excess inventory. And then we have the current increase in the ratio, which either means that gold prices are getting too high, or home prices are getting too low.
I think it’s hard to make the argument that home prices are getting too low.
[1] It is really hard to imagine how it cannot be true that today’s price matters for your return experience. The only way it could be irrelevant is if the growth rate of the asset is independent of the price, so that when today’s price goes up the expected future price goes up the same amount. But this leads to the absurdity that there is no price at which you wouldn’t buy an asset. I know this is really, really obvious to most of us but you have to realize that the belief that future prices are untethered to any fundamental value is the only reason the price of BTC – which can be redeemed for exactly zero, forever – is not zero. So lots of people clearly believe that everything has a ‘value’ if someone else will buy it today, even if no one will buy it tomorrow.
[2] People also hold gold for an end-of-the-world/fiat-collapse hedge. This is in my mind a separate case. If the price level goes up 500%, then the question of whether gold returns 490% or 510% is fairly irrelevant to me. The argument I am making is only salient for inflation at non-hyperinflation sorts of levels. Just want you to know I recognize that.
Illustrating the Cost of Leverage Effect on Returns
A couple of weeks ago, I presented a blog post called “The Effect of Crazy Time on Portfolio Allocations,” in which I pointed out that the effect of increasing volatility generally is to decrease the optimal portfolio allocations towards safer allocations. It was one of those posts where you initially say ‘well, duh’ but hopefully liked the fact that I ‘proved’ the intuition with the illustrations. While market volatility since then has been almost unbelievably low, it is hard for me to imagine that is sustained. It feels a little like a ‘deer in the headlights’ reaction from investors, as the Trump Train comes on so rapidly that all they can do is pull the shades.
I suspect that at some point, unless the Donald suddenly becomes a milquetoast business-as-usual kind of President, we will see those allocations shift.
But a few days ago I had another realization that called to mind the same old CFA-Level-I charts. I was explaining to someone who wanted me to leverage our really cool inflation-tracking strategy[1] that leveraging a mid-single-digits return makes a lot of sense when the cost of leverage is zero, but not so much sense when the cost of leverage was mid-single-digits. I’ve talked about this before – in October 2023 I published “Higher Rates’ Impact on Levered Strategies.”[2] I showed a table, but there’s a really simple way to illustrate the same thing.
I don’t really need the portfolio efficient frontier here. Maybe the optimizer spits out some share of the optimal portfolio that represents an investment in some hedge fund strategy you really like. Maybe it doesn’t. More likely, you don’t even use an optimizer. But if you really like that strategy, but want higher returns, you ask the manager ‘hey, can you lever that’? The manager says sure. But the manager can’t give you twice the returns for twice the risk – the leverage math doesn’t work that way. If the cost of leverage is 3% – which you can tell it is in this chart because that’s where the line hits the axis, at a risk-free rate of 3% – then your return for twice the risk is (2 x 4% – 1 x 3%) = 5%. So you pick up only 1% return for doubling the risk. And you can see that on the chart, because that’s the point the red line goes through: 5% return, 15% risk. For 3x risk, you get (3 x 4% – 2 x 3%) = 6%. And so on. The slope of the line is such that 7.5% additional risk gets you 1% additional return, no matter how many times you lever it.
So why do people ask for leverage? Well, because since 2008 the overnight rate was mostly at 0%.
If you can borrow at zero then levering simply multiplies risk and return simultaneously. At 2x leverage, your return is (2 x 4% – 1 x 0%) = 8%. You can see where this goes since 0 times anything drops out of the formula.
But this doesn’t work at higher costs of leverage. If the cost of leverage is equal to the expected return, then you just get more risk every turn of leverage you deploy. And if the cost of leverage is above the expected return, you make things worse every time you add leverage.
So it doesn’t make any sense to lever low-return strategies unless the cost of leverage is really low. And by the way, it doesn’t make much sense to lever high-return strategies unless they happen to be low risk. Because this math doesn’t just work with expected returns but also (and more importantly) with actual returns. Suppose you have a strategy that has a 6% expected return and a 15% risk. Say, an equity index. Now, you lever it 2x with the cost of leverage at 5% (by the way, if you use a levered ETF you’re not escaping the cost of leverage…but that’s for another day). Your expected return is now 7%, with 30% risk (check your understanding by doing the math).
Now, however, you get a 2-standard deviation outcome to the downside. Supposedly that happens only one year out of 40, but we know that there are fat tails in equity markets. But whatever the real probability, your unlevered return is now 6% – 2 x 15% = -24%. But now you’re riding the lightning and your return on the 2x leverage is (2 x -24% – 5%) = -53%. (Alternatively, you get to the same number if you just look at the new 7%ret/30%risk portfolio return as 7% – 2 x 30%).
Hedge fund managers understand this math…or should; if they don’t then get out…and it should change the numbers they report in forward-looking statements when interest rates are higher, for levered strategies. I will not comment on normal industry practice…
[1] To be clear, none of the red dots in this article represent the risk/return tradeoff for that strategy. I’m not trying to cagily present our fund’s performance because that would get me in trouble.
[2] This was a golden era for the blog. Right about the same time I also published one of my best posts in years, pointing out how the CME Bond Contract has shortened in duration and also has negative convexity again. “How Higher Rates Cause Big Changes in the Bond Contract.” How I loved that piece.
Growth. Does. Not. Cause. Inflation.
I am constantly amazed at certain articles of faith among the economics community. In my line of expertise, one of the most amazing to me is the absolute conviction with which the economics community believes that if the economy grows too fast, inflation will result and if it grows too slowly, disinflation or deflation will result. That this conviction is so strongly held is especially incredible, since there is essentially no evidence for that belief.
Theory says it is so. Growing too fast puts too much pressure on land, labor, and capital, which causes their prices to rise and therefore the price of the output. I mean, obviously.
Except that it doesn’t seem to have ever happened that way, at least for a long, long time.
Heck, let’s just take recent experience. In the last twenty years, we have had two global economic crises. The upheaval in 2008 was the largest since at least the Great Depression. The economic contraction in 2020 made the Global Financial Crisis look like a piker. So obviously, if we look at inflation it must have massively slowed down in those events, right?
Hmmm. Now, I’ve showed the Core CPI price level against GDP. If you squint, you can see a small deceleration in core CPI in 2010: it actually reached only +0.6% y/y at one point. We never even reached deflation, despite the fact that the GFC was triggered by housing and housing is by far the largest component of CPI. I don’t need to say anything about the COVID period because it is so recent. Core inflation vaulted higher, and continued to do so long after economic output had been fully restored to its prior level.
The other wonderful counterexample I like to show is the 1970s.
Notice there are several flat points here, where GDP was steady-to-lower and the price level kept on truckin’ (that’s a 1970s reference, kids). Notice that since I’m using core CPI, you can’t even say ‘well, the OPEC embargo caused energy prices to spike and that also slowed the economy.’ Yes, it did, but shouldn’t that slowing of the economy have taken pressure off of other non-energy prices? Well, it didn’t. Inflation was robust during the 1970s, despite growth that lurched forward and back in fits and starts.
Those are fun, visual aids but sometimes our eyes can deceive us and hide or exaggerate a relationship that is statistically present (or not). So here I did the economist thing and ran scatterplots at different lags. Each of these shows the y/y change in GDP on the x-axis (quarterly observations, since 1960 until 2024), and y/y changes in Core CPI on the y-axis. Chart A shows the y/y changes contemporaneously (1965Q1 vs 1965Q1, e.g.). Chart B lags the inflation one quarter, so we see if this year’s growth affected this year’s inflation but lagged a little bit. Chart C lags the inflation one year, so we see if this year’s growth affects the coming year’s inflation. And Chart D lags the inflation two years, so we see if this past year’s growth affects next year’s inflation.
The correlation coefficients, for your reference: -0.18, -0.13, 0.03, 0.14. That’s thin gruel on which to make a strong argument about growth causing inflation, in my mind.
Now, I’ve run these regressions since 1960 since the core CPI index only goes back to 1957. The same regressions with headline inflation show coefficients of -0.11, -0.05, 0.10, and 0.11. I’m actually surprised they’re not any better, because energy prices should be correlated with growth and flatter the relationship. The OPEC embargo does hurt that relationship, but even if we just run these regressions since 1980 the correlations between growth and headline inflation are just 0.13, 0.19, 0.16, and -0.09.
So where do we get the idea that growth causes inflation?
Well, if I look at GDP growth versus headline inflation, from 1929 until 1960, and I exclude 1946 when industry relaxed from its war footing and war-time price controls were removed, then I can coax a really nice correlation of 0.73.
Indeed, if you look at the correlation between 1929 and 1945, it becomes a whopping 0.88. That’s science, baby – fitting the data to the story! But now I think we get to the heart of the matter because something else momentous happened in 1948 and that was the publication of the first edition of the most-used textbook in history: Paul Samuelson’s Economics. It is no surprise, perhaps, that generations of economists learned this ‘fact’ based on a correlation of 0.88…that has been falling ever since.
Since that time, the correlation between core inflation and growth has been low, and sometimes even negative, over very long periods. If there is any causal relationship, it is completely swamped in exceptions. Decades-long exceptions. It is time to give up this idea. One unfortunate consequence of that is that the way the Federal Reserve operates is as if there is one dial it can turn and that is ‘the dial that increases growth until inflation gets hot, then decreases growth.’ The problem is that isn’t one dial, it’s two. In general, I think the Fed should keep its hands off the growth dial, but if it wanted to meddle on rare occasions it would do so by manipulating medium-term interest rates. To control inflation, it needs to moderate the growth of the money supply. Frankly, in my opinion the FOMC should simply focus on the latter mission and let growth, and markets, take care of themselves. They’re not good at any of these missions anyway.
Inflation Guy’s CPI Summary (January 2025)
We finished 2024 with a slightly soft reading, but we began 2025 with a hot reading. Now, my admonition last month about the volatility of December data applies also to January data, although less so in CPI than in some other indicators. However, averaging December and January is probably the right approach.
It still doesn’t look great even if you do that.
Let’s start with the market changes over the last month. You can tell from the table below that short inflation expectations as measured by the column on the far left have come up some, although not as much as you might have expected given all of the concern about tariffs. (For what it’s worth, in this table you can ignore the huge increase in 1-year breakevens – there really isn’t any such animal per se, and Bloomberg’s choice of bonds to use for the 1-year can change that a lot. Focus on the inflation swaps, which is a purer measure.)
The consensus estimates coming into today were for +0.30% on Core CPI and +0.29% on headline CPI. That represented an acceleration over the nice inflation data we saw in December (the best core inflation print since July!), but was expected to be attributable to one-offs such as wildfire effects. In fact, the number printed at an alarming +0.47% on headline and +0.45% on Core CPI, the worst since April of 2023. Here are the last 12 months.
But we are jaded these days because we’ve seen higher figures. Let’s back out a bit. Prior to COVID, we hadn’t seen a Core CPI number this high since 1992!
Okay, so some of these are one-off causes. And it is a January figure after all. Median CPI will be better. My calculation had it around 0.35%, but since the BLS changed weights for the new year in this report I am less confident in my estimate than usual. It should be close. And since last January was a big median print, that means the y/y median would drop to 3.66% or so on base effects. But there certainly doesn’t look to be any really marked improvement here.
Speaking of the reweighting of the CPI: this always sparks conspiracy theories even though the reweighting is very transparent. And the changes are pretty small year to year. Here are the changes from last January’s weights.
The BLS also announces categories that are being dropped or added or renamed. I never point those out because it’s really boring. At least, it is normally. This year, the BLS announced that the series for “Pet Food” has been renamed to “Pet Food and Treats.” Because who’s a good boy? That’s right, you’re a good boy.
Let’s look at some of the main culprits for the upside miss this month.
- Used Cars SA +2.19% m/m – We all expect some upward lift after the wildfires, but I am not sure this is due to that. New Cars CPI only rose +0.04%. But this is the highest m/m increase in Used Cars since 2023
A bigger concern with Used cars is the upward tilt in the overall price level. Remember that the spike during COVID (which happened thanks to the geyser of money that sprayed American consumers who had little else to buy, and few new cars being produced) was a big bellwether and/or driver (mathematically speaking) of the increase in core CPI post COVID. The unwinding of the spike in used cars pushed Core Goods inflation lower and lower, and dragged down Core CPI. But now it looks liked used car prices are again headed higher. This seems a good time to mention that M2 is also inflecting higher. The money supply is 40% bigger than at the end of 2019. Used car prices are only 32% higher. I think the deflation in used cars is over. (I’ve included M2 on this chart.)
AS a consequence of this, and despite apparel being -1.4% m/m (that’s one place tariffs could bite since we don’t produce any apparel in the US…on the other hand, there are lots of suppliers of apparel globally so absent a blanket tariff, we might not see a big effect), Core Goods CPI y/y went to -0.10% from -0.50%. As I’ve noted previously – ad nauseum, probably – to get inflation to 2% you need core goods inflation to stay negative, and pretty decently so. Core Services dipped to 4.3% y/y from 4.4% y/y, but obviously if that part is over 4%, and it’s the bigger part, you need Core Goods to stay flaccid.
- Health Insurance rose +0.74% NSA. Health insurance inflation jumps sometimes in January, so this is not something I’m worried about (plus, the health insurance number is really only calculated once a year and smeared out over the year). But it’s worth noting.
- Lodging Away from Home, +1.43% SA. Normally this is one of those categories that jumps around a lot and so we would expect a reversal next month, but with the wildfires in California I’d expect this to be buoyant for a while even if it is just the Western US being affected. But don’t forget that there are lots of people without homes still in North Carolina. On the other hand, if deportations ramp up a lot more than they currently are this is one place where pressure on prices could be relieved since many illegal aliens are housed in hotels at the expense of the local/state/federal government. That disinflationary effect, though, is months away at best, I think.
- Pharma had a huge month, rising 1.4% m/m SA. That’s the biggest monthly gain in decades. I suspect some of that is because pharmaceutical companies know that they are ‘on the X’ of President Trump’s ire after actively working against him in 2020. The President has recently been talking about how upset he is about US drug prices relative to the same drugs sold in other countries. This is a real threat – in his prior term, he talked about implementing a “Most Favored Nation” clause when it comes to pharmaceuticals (I wrote about it here: https://inflationguy.blog/2020/08/25/drug-prices-and-most-favored-nation-clauses-considerations/ ). So it strikes me as possible that pharmaceutical companies were raising prices in January partly so that they can cut them with great theatrics to show their ‘support’ for the President (and hold off most-favored-nation as long as possible). I do not expect to see this repeated next month, unless tariffs affect APIs (active pharmaceutical ingredients) in the near-term.
- Hospital Services were also high, at +0.95% m/m SA, but this is less unusual for that series which jumps around a lot like Lodging Away from Home. Still, that was the highest print since March.
On the good side – while Rent of Primary Residence was a little higher than last month (+0.35% vs +0.30%), OER was the same (+0.31%) and rents overall continue to decelerate. However, they are decelerating at a declining rate. It looks like the dip that I expected is never going to happen, as the growth rate of rents looks to be converging with our model in the high 3s. And it doesn’t need to be repeated, but I will anyway, that there is no sign of broad deflation in rents coming.
Food and energy were additive this month, although less than I expected. Food at home was +0.46% m/m, and I expected about double that. Eggs were +13.8% m/m (NSA), and +53% y/y, and are getting a lot of press. But that’s not an inflation thing, that’s a lack-of-chickens thing and egg prices will eventually come down (in, approximately, the time it takes a chicken to get to adulthood). Food away from home was relatively tame at +0.24%.
So what’s the big picture?
What we saw today was mostly the trend. I continue to think that the new ‘middle’ on Median CPI is the high 3%s, low 4%s area, with occasional forays above and below that level. Over the course of 2025, as tariffs are implemented, we are likely to see a slightly higher run rate. Tariffs are a one-off, and they aren’t a large effect unless applied in a blanket way to all imports. Remember (and review my recent blog https://inflationguy.blog/2025/01/29/trump-tactical-targeted-tariffs-a-reminder-of-the-impact-of-tariffs/ and podcast https://inflationguy.podbean.com/e/ep-131-how-tariffs-affect-you-three-things-you-maybe-didnt-know/ on the topic) that despite what some hyperventilating Congresspeople say, consumers do not usually pay the majority of a tariff except in narrow circumstances where demand for the good from that particular supplier is inelastic. If the Trump Administration imposes a blanket tariff of 20% on all imports, with no exceptions, it might cause an increase in inflation of 0.5%-1.0%. But that’s a one-time (level) effect unless tariffs keep being ramped higher, and the effect gets smaller the higher the tariff goes (a 1000% tariff will not raise prices any more than a 900% tariff, because at that point we aren’t importing anything). So, all else equal, we should expect slightly higher inflation in 2025 than we previously would have expected, and probably for the first part of 2026, but then the tariff effect will be over and the level of inflation we settle in at will be once again driven mainly by money growth.
On that score the news isn’t great, with M2 rising at a 5.8% annualized rate over the last quarter and 3.9% over the last year. 4% would get us to 1.5%-2% inflation in the long run, probably; 6% will get us into the high 3s, low 4s. Some think that if inflation ends up ratcheting a little higher, the Fed might raise interest rates again. But monetary policy has very little control over inflation that is caused by tariffs and it would make no sense to reverse course for that reason. This just accentuates how bad the box is that the Fed got itself into by making a nakedly political ease in the middle of last year. Tightening because of tariffs has no economic justification; it would look nakedly political again. I would be surprised if overnight rates went higher from here. Of course, I’d also be surprised to see them going lower especially since tariffs are also good for domestic economic growth.
So there will continue to be lots of economic volatility from here, but stasis appears to be high 3s, low 4s. Still.
The Effect of Crazy Time on Portfolio Allocations
I am continually fascinated by how many second-order ‘understandings’ are missed, even by those people who have a really good first-order understanding of finance. For example, every financial advisor understands that bonds are less volatile than stocks. Most financial advisors understand that stocks and bonds in a portfolio together also benefit because they’re not correlated. Some financial advisors, and most CTAs, understand that diversifying a portfolio works because when you add uncorrelated assets together, the risk of the whole is less than the sum of the risks because of the offset from the correlation effects. Those are all coarse understandings that any financial professional should ‘get.’ However, it is fairly unusual for advisors or even CTAs to understand that the correlation of stocks and bonds undergoes a state shift when inflation get above about 2.5% for a few years, and become correlated, and that means more risk for the same combination of stocks and bonds. Here’s that chart I love to show, updated through the end of the year.
While that’s an example of a ‘second-order understanding’ that isn’t widely known, it isn’t what I want to write about today. Actually, for a change what I want to discuss is something that has nothing directly to do with inflation, and that is the effect of volatility on asset allocation.
This is an important discussion right now, because whether or not you have gotten the message yet that President Trump is going to be much more Machiavellian in his approach to the global world order than prior Presidents have been – and whether you think that’s a good thing or a bad thing – you surely must have noticed that the volatility of the markets under this regime is likely to be somewhat higher than under Sleepy Joe and also higher than it was during Trump’s first term. And that leads to the second-order understanding about what that implies for markets. Hang with me here; if you’re not a finance person this gets a little hairy.
The next chart shows Modern Portfolio Theory on one chart.
The blue line is the Markowitz efficient frontier: every point on the line represents a portfolio of assets that is the least-risky for that level of expected return. So, the highest vertical point is a portfolio of 100% in the asset with the highest expected return…you can’t get more return without leverage.[1] In this case, let’s assume that is equities. As you go down the curve, you allocate more to other less-risky assets and give up some portfolio return. Because assets are not 100% correlated, you can always get a portfolio that has at least as good (and usually better) returns for a unit of risk than any single asset – that’s the benefit of diversification. As you get to very low expected returns, you get to the part of the curve you’d have to be irrational to be on because you get higher risk and lower returns, and so we usually ignore that part of the curve that bends back.
The red line is popularly called the “Capital Asset Line.” Assuming there is some zero-risk instrument (that’s not already in the assets we’ve considered, so there’s some hand-waving here) and you can both borrow and invest at that rate, you can think of a portfolio that is the ‘best’ portfolio on the blue curve, either combined with the zero risk instrument (sliding down the red line to the left) or levered at the zero risk instrument (moving up the red line to the right). The ‘best’ portfolio here is defined as the place where the red curve is tangent to the blue curve.
A lot of times you’ll just see those two lines, but it doesn’t answer the question of which portfolio an actual investor prefers. It turns out that investors do not have linear risk preferences…that is, if I make my portfolio 10% more risky, perhaps I require 1% more return but if I make it another 10% risky, I’m going to need more than 1% additional return. I’m not only risk averse, but I get more risk averse the larger the potential risks. [Lots of experimental data on this. If I offer you a bet where you pay me $1 and on the basis of a coin flip I will either pay you $2 or $0, you are much more likely to take that bet than if I offer you a bet where you are risking $10,000 for the chance at $20,000…or zero]. So the purple dotted line is a hypothetical ‘investor indifference curve’. I just made up that term because I can’t remember what the theoreticians call it. The curve represents all of the combinations of risk and return that make the investor equally happy. So, the best portfolio for this investor is where the purple line – the highest purple line we can find, indicating the MOST happiness – touches the red line.
With me? Now consider the next chart. All I have done here is to increase the risk of every asset and shift the whole portfolio efficient frontier to the right.
What happens? The Capital Asset Line (red) now flattens out. And that means that the prior purple line no longer has a point of tangency. We have to go to a lower purple line, and since the purple line is concave upward the red line becomes tangent to the purple line at a point further to the left (the slope of the red line is flatter, and the flatter parts of the purple line are to the left). I’ve put the new ‘optimal portfolio’ as a dot in purple.
The implication is this: if overall risk in markets is perceived to have permanently increased, then rational investors will move from portfolios with more risky assets to portfolios with fewer risky assets.
You probably could have guessed that without all of the curves. If I am comfortable with a certain amount of risk, and the overall risk of things goes up, then it stands to reason that I’d work to reduce my overall risk. The second-order understanding here is, then, that if President Trump is perceived by investors to increase the overall volatility in markets and individual country and company outcomes, we should expect investors to lighten up on equities.
And that brings me to the final chart. This is the Baker, Bloom and Davis news-based Economic Policy Uncertainty Index, which counts the number of articles in US-based news sources that contain a set of predefined terms that indicate uncertainty about economic policy. The dotted lines below show weekly data; the heavy red line shows the 12-week moving average to get rid of the noise.
Notice the three prior spikes on the chart are during and immediately following the end of the internet/stock market bubble in the early 2000s, the end of the housing bubble and the Global Financial Crisis in 2008-09, and the COVID crisis. All three of those episodes were associated with significantly lower markets, although you could argue that harsh bear markets might trigger some policy uncertainty (that certainly happened after 2008). The jump on the right is the Trump jump, and it is already higher than any other period on this chart other than COVID.[2] Volatility we have. Uncertainty we have. And even if you like the President’s policies, the volatility means that we should not be surprised to see investors pull some chips off the table.
[1] If you take this best-returning asset and leverage it, you basically get a straight line going up and to the right forever; the slope of the line depends on the cost of leverage.
[2] Incidentally, the index goes back to about 1985 and although I didn’t show it there are two more bumps that are similar to the leftmost two on this chart: around the 1993 recession, and around the time of the stock market crash in 1987. They are all lower than the Trump jump.
Trump Tactical Targeted Tariffs: A Reminder of the Impact of Tariffs
Representative Alexandria Ocasio-Cortez, aka AOC, recently railed against the President when he threatened Colombia with tariffs if they should refuse to accept their citizens being deported back to them. In her typical hyperventilated fashion, she implored us to “remember” that “WE pay the tariffs, not Colombia.”
For a change, AOC is not entirely wrong but merely mostly wrong. She seems to remember at least one important thing from Econ 101 and that is that businesses don’t pay anything to anyone, since a business is just a legal structure. Shareholders, other stakeholders, consumers, or suppliers pay and/or receive the cost of goods sold, taxes, wages, and so on. Unfortunately, I don’t think that was her point and she missed the important bit which is that ‘who pays the tariff’ depends almost entirely on the elasticity of demand for the product. Here are two charts. In each case, the tariff shifts the supply curve leftward/upward by the amount of the tariff, the same amount in both pictures. In each picture, the quantity consumed of the good being tariffed goes from c to d and the price goes from a to b as the market moves from one equilibrium to the other.
The first chart shows an inelastic demand curve, which is characterized by the fact that large changes in price do not change the quantity demanded very much. In this case, the main effect is that consumers buy almost as much of the good, but the price moves almost the full amount of the tariff. Consumers end up paying most of the tariff.
The second chart shows an elastic demand curve, in which even small changes in price induce large changes in the quantity demanded. In this case, the main effect is that consumers buy much less of the more-expensive good, and the price goes up only a little so that the seller bears most of the cost of the tariff.
Thus a blanket statement that “we pay the tariffs” is wrong. It is sensitive to the characteristics of the product market. One needs to be very careful about how we define the product market because it matters. I would argue that the elasticity of the demand for coffee is quite low, which is why Starbucks even exists. If the demand for coffee was very elastic, charging $5 a cup for bad coffee would not produce a line around the block at rush hour. But that is not what we are talking about here. The question here is, what is the demand elasticity for Colombian coffee? The answer to that question is very different. Coffee as a way to wake up in the morning has few close substitutes. But Colombian coffee has many, very very very close substitutes. My favorite right now is Ethiopian Yirgacheffe coffee. I also like a good Panama Boquete. Add 20% to the cost of the Boquete, and I think I’ll mostly drink the Yirgacheffe. Add 20% to both of them, and I’ll go to Brazilian Santos, or Colombian, or Kona.
I think the reaction of the Colombian President tells you everything you need to know about what he perceives about the demand for Colombian coffee and therefore the impact a tariff would have on exports of Colombian coffee to the United States. Trump very quickly got what he wanted with his Trump Tactical Targeted Tariffs (TTTT™). So to review: +1 for TTTT, -1 for AOC.
A couple of other points about tariffs and tariff strategy.
First, this episode illustrates a very important distinction to be made between the use of targeted tariffs and the use of blanket tariffs. Blanket tariffs, for example on everything we import from a major trading partner or on every trading partner, definitely increase prices for consumers. How much, and which prices, depends on how easily domestic untariffed supply can substitute for the imported supply. But the answer is certainly that prices go up. But let me point you to two articles I’ve written previously about this:
Tariffs Don’t Hurt Domestic Growth (https://inflationguy.blog/2019/08/28/tariffs-dont-hurt-domestic-growth/), August 28, 2019. This is a really good piece. In summary, tariffs are bad for global growth but they are not the unalloyed negative you learned about in school. How good/bad they are for growth depends on whether you are a net importer or a net exporter, and how large the Ex-Im sector is in your country. Truly free trade works in a non-theoretical world only if “(a) all of the participants are roughly equal in total capability 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.” Really, you should read this.
The Re-Onshoring Trend and the Long-Term Impact on Core Goods (https://inflationguy.blog/2022/02/22/the-re-onshoring-trend-and-the-long-term-impact-on-core-goods/) February 22, 2022. This is not directly about tariffs, but the broad imposition of tariffs (if they happen) should be thought of as reinforcing this prior trend. The prior trend, of re-onshoring production to the US, has been under way for several years – the way that COVID exposed long supply lines certainly helped the trend but the long-term globalization trend was already reversing and in this article I argue that this means core goods inflation going forward is likely to be small positive, rather than persistently in deflation. In the context of the current discussion, President Trump has certainly made re-onshoring of production a major goal of his Administration. So whether it happens because of TTTT, or because of blanket tariffs, or because of tax breaks given for domestic production, the direction of the inflation arrow is clear.
I’m not worried about hyperinflation from tariffs and I think that if you’re the biggest and the strongest economic actor they’re probably more good than bad for domestic economic outcomes.
Reality is more nuanced than we learned in school. Not everything that expands the economy is good, and not everything that is good expands the economy. Not everything that is bad causes inflation to go up, and not everything that causes inflation to go up is bad.
Framing Home Price Inflation
The ever-increasing cost of homes obviously causes a lot of people a lot of angst. Chief among those groups, naturally, are the people who are planning to buy a home but do not yet have one; and, since higher home prices are very highly correlated with higher rents, renters too are alarmed that the rent is too damn high! (if that reference eludes you, educate yourself at this link: https://www.youtube.com/watch?v=OUx_32ABtw4 )
Right behind the people who have to actually buy homes and rent apartments, though, are the economists who seem to be perennially alarmed that home prices are “in a bubble” again. Certainly, if you look at nominal home prices (represented here by the S&P Case Shiller U.S. National Home Price Index, normalized like all of the charts in this article so that December 31, 1989 = 100 and the latest figure is for the end of September 2024) then you can see the cause for concern. Home prices are up 75% since the peak of the home price bubble of the late 2000s! If a house at $241,000 was in a bubble in 2006 (and subsequently declined in price to 175k), then surely it’s in a bubble if it’s now at $425k?
You can see in this chart the rapid acceleration in 2021-2022, and that should be a clue about one of the things that is going on with home prices. The overall price level is a lot higher than it was in 2006; the dollar simply doesn’t go as far as it did back then. Indeed I’ve chronicled how, thanks to the supercharged increase in the money supply, consumer prices are up 23% since just before COVID. Obviously, then, we have to adjust the dollar price of a home for the change in the measuring stick (the dollar) itself. Here are real home prices.
This still looks like a bubble, if real home prices are 13% higher than the bubble peak. After all, homes are unproductive real assets. Over a long period of time, home prices have risen less than 0.5% per year after inflation. In this way a home is like a lump of gold. Ten years from now, the lump of gold is still a lump of gold and so you would expect the real return to be roughly zero (you have the same amount of stuff at the end that you started with). In the case of home prices, there is deterioration of the housing stock over time but also new construction and homes have historically gotten larger and more comfortable, so some small drift higher in real prices makes sense. But home prices since 1989 are up 70% in real terms, when they should be up roughly 25 * 0.5% = 12.5%. And since the 2006 peak, we’d expect 9% (18 years x 0.5%) would represent a similar peak. We’ve risen more than that!
So, definitely a bubble, right? That deflation everyone keeps promising us is imminent, along with the collapse of banks and all the other stuff? Not so fast; there is one other important thing to consider and that is household formation. Or, rather, household formation compared to housing-unit formation.
We start by imagining what could plausibly push real home prices above or below a long-run flattish trend, that would represent a legitimate effect and not a bubble. What immediately comes to mind for me is the fact that for at least the last few years we have seen a massive increase in the US in the number of heads over which we need to put roofs. Something in the ballpark of 10 million new residents need roofs, and we surely have not constructed that many new roofs. For a long time, I’ve been highlighting this as one really good reason to not expect rental or home price deflation: the demand relative to the supply is out of whack. However, it turns out that we don’t actually need to rely on the ‘unofficial’ increase in the population to conclude that the “bubble” isn’t so bubbly.
The chart below, covering 2004 to the present, shows the real home price (the second chart above) on the y-axis. On the x-axis, I have a ratio of the number of households in the United States (source: US Census Bureau) divided by the total number of housing units in the country (source: US Census Bureau). As the ratio moves higher, it means there are more households for every housing unit or alternatively, fewer vacant units. I only have the housing unit data back to 2004, as that’s what was on Bloomberg.
There is a pretty clear relationship here between real home prices, and the occupation ratio. I have highlighted two areas. One, in red, is the January 2006 through June 2007 period – sort of the teeth of the housing bubble. Those points are well above the line, suggesting that prices were high relative to the occupation ratio. In fact, January 2007 is the point that is the highest above the regression line. On the other hand, we have the most-recent point in green. This is right on the regression line. Yes, real home prices have gone up a lot. But that’s mostly because the construction rate of new housing units has not kept up with household formation.
As an aside, the three points at (0.91, 130) or so are from mid-2020, when there was a surge of household formation but home prices (and rents) were being constrained by the lockdowns. In retrospect, it was a great time to buy a house!
Note that the charts above do not include undocumented residents in the US, except inasmuch as the Census Bureau is including them. Since the total increase in households since January 2021 is only about 6mm…and for the prior 4 years, the increase was 5mm…I am fairly confident that the recent surge in illegal immigration is not reflected on this chart. Ergo, you could make the case that home prices are too low in real terms. If every 5 illegals form one household, the ratio would rise from 0.912 to 0.926, and we would be off the chart to the right-hand side.
Now, this does not mean that real home prices will not decline. In fact, I am very confident that at some point they will, as building catches up with household formation. That does not mean that home prices will fall in nominal terms, however; I suspect that what is more likely to happen is that over a number of years, home prices will drift sideways to slightly higher while overall consumer prices continue to rise. But, if 10 million illegal immigrants are deported, the building of new units will catch up a lot more quickly and nominal prices and rents could decline in that case.
If that happened, rents really would be ‘too damn high’. And that is one very big reason that mass deportation is not inflationary. It also is not very likely; I have the over/under at 1mm deportations.
Inflation Guy’s CPI Summary (December 2024)
It is important – and I say it every year – to remember that when we are looking at economic data from December (and in many data series such as Employment, January as well) there are massive error bars around the numbers. The government doesn’t report error bars, but they should. Frankly, when it comes to Nonfarm Payrolls, I barely glance at the number because it just doesn’t mean very much.
The problem isn’t so dramatic in CPI at the headline index level, because the main sources of volatility in the index also happen to be the ones that provide all of the seasonal adjustments, so we tend to miss estimates roughly as often in December as in other months. As we go through the numbers today, however, you’ll notice a bunch of things swinging one way after swinging the opposite way last month. That’s the sort of thing that can easily be caused by the placement of Thanksgiving, so you can see reversals from November’s number to December’s. I am not saying that everything in the CPI report today is infected by that effect; just keep it in mind.
Now, while I say the ‘problem’ of seasonal volatility isn’t as bad in CPI at the headline level, recognize that December sees the most-severe seasonal adjustment to the headline figure. Here are the seasonal adjustment factors for 2023 (they don’t change much). A number below 1.0 means that the seasonally-adjusted headline number will be higher than the nonseasonally adjusted number, because the seasonal pattern ‘expects’ the weakness, and vice-versa. You can see that December is the month furthest from 1.0. What you can’t see from this chart is that if you want to get technical about it, December is also the only month for which we could really reject the null hypothesis that the adjustment factor is 1.0…in other words, the only month where we are really confident that the effect is to cause the NSA CPI to be lower than the average month. November, maybe.
As an aside, this is why April maturity TIPS tend to have higher yields than January maturities. The January TIPS mature to an index that is an average of October and November CPIs, while April TIPS mature to an index that is an average of January and February CPIs. So April TIPS always get an extra December CPI in them, and if there’s one month you don’t want, it’s December. So April TIPS have to have a slightly higher yield to entice people to hold them.
Right, that’s a big prelude discussion. Summing up: don’t get too excited either way with this number. More important is that the overall market has been selling off. 10-year breakevens have risen 14bps, and 10-year real yields have gone up 26bps. How much of this is because of a fear that inflation is turning, is unclear. But in December, the overall data was pretty close to expectations. Core inflation came in at +0.225% m/m, compared to expectations of +0.25%, which is less dramatic than it looked when rounded and it printed at 0.2% vs expectations of 0.3%. A small miss lower, and to be fair the best core number since July.
Headline was only 0.04% NSA…which gets adjusted to +0.39% when the seasonally-adjusted number is reported. See what I mean? So we look at the y/y numbers, which basically replaces last December with this December (thus neatly avoiding the seasonality issue). Y/Y headline CPI rose from 2.73% to 2.90%, and Y/Y core fell to 3.25% from 3.30%.
You may notice that none of those numbers looks like it’s at 2%. Nor is Median CPI, which was (my estimate) +0.31% m/m, the highest since September. If I’m right about that print then the y/y would drop to 3.86% from 3.89%.
So on the macro side, top-down, this does not look like the sort of data that the Fed was expecting when it started easing in September. Since in my opinion this has been eminently foreseeable for a long time when you looked at what was driving CPI, the conclusion must be either that the Fed is just incompetent when it comes to inflation forecasts, or it doesn’t care about inflation, or the rate cut had nothing to do with economics and was just a political gambit to get Harris elected. None of those answers is flattering. I suspect answers #1 and #3 are the main drivers of the most-recent policy error.
The good news in the inflation figures is that there’s no one major group that still looks alarming.
When we drill down to the monthly data this month…that’s where you see the seasonal volatility. For example:
- Used Cars was expected to be roughly flat. It was +1.2% after +2.0%.
- Rents rebounded; OER and Primary Rents were +0.31% after +0.23% and +0.21% respectively last month.
- Lodging Away from Home was -0.95% this month; it was +3.16% last month.
- Airfares were +3.93% this month; they were +0.37% last month.
- Car and truck rental +0.58% this month; -2.99% last month.
- Baby Food +0.42% this month; -0.12% last month.
- Medicinal Drugs +0.08% this month; -0.10% last month.
- Doctors’ Services was lower, +0.06% vs +0.28% in November; but Hospital Services were higher at +0.23% compared to 0.00%.
A few broader observations. Core Goods and Core Services both continue to move back towards zero: goods from underneath and services from above. CPI for Used Cars is still -3.4% y/y, and I’d expect it to slowly recover from the spike and reversal stemming from COVID. But we now have an extra factor, and that’s the devastating California wildfires. There are two things you see burned out in every picture. Vehicles, for one. Used and New car inflation is going to turn higher, and maybe quite a bit, going forward as people in California need to replace their wheels. Over the medium term, the dollar’s strength would help keep core goods inflation tame and even slightly negative, but thanks to the wildfires we are likely to see core goods back above zero shortly.
And the other thing you see burned out, of course, are houses. Primary Rents have been slowly converging with our model, but rents are going to get goosed in California immediately and that effect will be smeared out because of local laws against ‘price gouging’ that prevent landlords from hiking their rents immediately to the equilibrium level implied by lots more demand and lots less supply. So they’ll hike, but it will take longer. This is mainly a California effect, naturally, but it will be large enough to affect the national numbers.
Incidentally, you’ll also see these in Lodging Away from Home inflation not just in California but in the entire western US. And maybe further, since remote work makes it possible to temporarily relocate almost anywhere. Federal support of the displaced will ensure that is not a 1-month effect. So in shelter, January and February (and beyond) numbers are going to be a lot more important than today’s release.
I am sure that will be used later to argue that “this inflation in 2025 is all due to the wildfires,” but we should remember that inflation in 2024 was (at best) leveling out and possibly hooking higher again. Broad core inflation ex-shelter has now risen four months in a row. It isn’t alarming, at 2.12%, but it isn’t just shelter keeping inflation above target and the story in early 2025 won’t be ‘all about shelter and cars.’ Supercore is also improving, but it isn’t going to pull the overall CPI down to target if Shelter doesn’t keep decelerating and as Core Goods goes back positive.
Supercore is indeed looking better, but we still have wages rising at 4.3% y/y. Remember that wages and supercore are modestly cointegrated. Or, in English, supercore is where wage-driven inflation tends to live. Wage growth needs to soften a lot more in order to get supercore back to target-like levels.
Again, all of this is December and in January we have had a massive natural disaster that will affect inflation data as soon as next month – and for months going forward. This will obfuscate the fact that the Fed already made a second policy error (after the COVID-era error of adding too much liquidity and not pulling it back quickly enough), dropping rates prematurely and letting money growth re-accelerate (M2 y/y is at 3.7%, but annualizing at 4.7% over the last 6 months and 5.8% over the last quarter ended in November). The bottom line is that the December inflation data is just not very important. What happens next…and what is already happening…is the story that will drive inflation and markets in 2025.
(Admin note: I missed doing the CPI Report podcast last month but it will post this month again! In roughly an hour, I suspect).
Inflation Market Valuations and Tactics in the New Year
There is so much to talk about, since it has been such a long time since I posted, that it is a little hard to know where to begin. So let’s begin 2025 with a few quick notes about inflation markets and markets generally. I wouldn’t call this an outlook, per se…I am trying to resist making that year-end/year-beginning offering to the jinx gods…but an update with some observations. As an aside, later today I’m planning to post a new Inflation Guy Podcast (this is a Podbean link but it’s available anywhere you get your podcasts) with some comments on the trajectory of inflation (as opposed to markets), and how that may be affected by things such as the massive California wildfires.
I will begin with a content warning: this note is much denser than most of my columns. If you’re a retail investor and/or only interested in developments in inflation rather than inflation instruments, then you might skip this one. I’ll talk more about expectations for inflation, of course, in other posts. But that’s not today’s post.
Let’s start by looking at 10-year real yields. The blue line in the chart below is 10-year TIPS yields; the black line (because it’s topical) is 10-year UK Gilt linker (real) yields. TIPS yields are up to 2.25%. Normally, when they get to around 2% I think of them as roughly fair in an absolute sense, because long-term risk-free real yields ought to in principle look something like long-term real economic growth. Instructive in the chart below is that as far as nominal UK yields have risen, inflation-linked yields are still well below US real yields.[1]
That’s partly a clientele effect, since there are many forced holders of UK linkers. But still, while US real yields ran up from -1% to +2.25% once inflation started (that is, TIPS declined in a mark-to-market sense when inflation went up – very, very important to understand if you think of TIPS as an inflation hedge. They are, but only at maturity), Gilt real yields went from -3% to +1.19%. The selloff was 100bps worse. Yikes.
The next chart shows my quantitative measure of relative cheapness (negative indicates richness, because I’m a bond guy). I said before that TIPS are now roughly fair in an absolute sense; relative to nominal bonds, they’re also roughly fair to slightly cheap. That’s the blue line. You can see that TIPS for most of the past decade were pretty cheap relative to nominals (even while they were absolutely rich because of negative real yields), but since people started caring a bit about inflation they’ve gone back to being mostly fair. However, Gilt linkers have been massively rich for a long time – again, because of the forced-holders problem. But they are starting to get cheaper. That 100bps greater selloff I mentioned above happens to show up here as 100bps cheapening relative to nominals, and relative to TIPS!
Today’s column is supposed to be mostly about US markets, but I can’t help myself. I ought to also point out that breakeven inflation in the UK is roughly 100bps higher than it is in the US, even though core inflation in the UK is 3.6% and in the US it’s 3.5%. So, possibly, part of the relative richness of UK linkers – since I’m looking at each country’s linkers in relation to its own nominal bonds – is actually cheapness of UK nominals, compared to the actual inflation there. Or maybe it’s the richness of US nominals, compared to the actual inflation here. (This is why relative value trading is so useful and important – we don’t need to have an opinion about which of these two things is true. Are US nominals too rich, maybe because they can be financed cheaply in repo markets at ‘special’ rates? Or are UK nominals too cheap, maybe because the UK budget situation is perceived to be somehow even more precarious than our own? I don’t know.)
Sorry about the digression there to the UK. I just got excited. The inflation markets and inflation in Japan are also really interesting right now, especially as wage growth is surging and the yen is bordering on collapsing…yet 10-year inflation in Japan is quoted around 1.5%. If you can get someone to transact. Maybe I’ll talk about Japan another time.
US markets. First, note the weird shape of the US CPI swaps curve.
I have several issues here, with one of them being the overall optimism that inflation is definitely going back to be close to target, despite any real sign that is going to happen. It borders on religious conviction, frankly. But also, we have a weird implied path where inflation droops, then spikes near the 10-year point, and then declines. To be sure, I’m committing a chart crime here with the y-axis; if you stepped back this would look almost flat. But this is more than enough for a hedgie to be interested, usually. What is really happening is that if we had a core inflation swaps curve (I do, but you don’t) it would show a gentle decline out to 8 years. It’s steep on the CPI swaps curve because the energy curves imply that energy inflation will drag core inflation lower for years.
Of course, they won’t but you can hedge the energy. Out to about 5-8 years, probably. And that’s probably why we have that little dip in the CPI curve – it’s really an energy thing.
So I’ve said that 2.25% real yields on TIPS are fairly attractive. About as attractive as they’ve been for some time, actually. But be aware of a couple of things. One is that the bond market as a whole is under pressure and probably will stay under pressure for a bit as investors worry about financing the government in a world where the trade deficit is probably going to be coming down (implying that domestic savings will have to go up, and the only good way to make that happen is with higher yields). Real yields could go higher, and probably will at some point. But you should recognize that seasonality works in favor of the TIPS buyer right now.
Breakevens have a strong tendency to rise in the early part of the year. In 22 of the last 26 years, 10-year breakevens have risen in the 60 days following January 8th. To be sure, some of that is because TIPS bear flat-to-negative accretions in the early part of the year because CPI in December almost always declines on an NSA basis, so the rise in price/decline in real yields that helps widen breakevens is partly reflecting a change in the source of total return in TIPS during those months to being more price and less yield.[2] The point being that buying nominal bonds in the beginning of the year, up until about May, runs into difficult seasonal patterns but this is not true with TIPS. Indeed, it means that if you’re buying fixed income at all in Q1, it probably should be TIPS.
Finally, I really should say something about equities here. I think it’s always important to realize that TIPS yields are a direct competitor with equities. Nominal yields are not, necessarily, because 7% nominal yields in a world where prices (and earnings) are going up at 9% are much worse than 5% nominal yields in a world where prices (and earnings) are going up at 3%. Equity earnings do tend to rise with inflation (but stocks are a poor inflation hedge because multiples also tend to contract significantly when there is inflation, so you need to hold equities for a long, long time for them to be a good inflation hedge), and since they do it means that inflation-linked yields are a more-fair comparison. Real yields at 2.25% are neither rich nor cheap in the grand scheme of things. But equities are, once you discount expected earnings growth for expected inflation. I calculate the expected long-term S&P real return assuming that the current multiple of long-term average earnings (the Shiller PE) reverts 2/3 of the way to its mean over 10 years. By making it 10 years, and not demanding full reversion, I lessen the impact of apparent overvaluation on expected returns. But high returns do, historically, tend to precede low returns! In any event, you can debate my approach but below you can see my point.
This first chart shows 10-year TIPS yields set against my calculated expected 10-year annualized real returns from the S&P 500. Granted, the S&P 500 is cheaper outside of the Magnificent 7. But you can see that while stocks and TIPS cheapened together in the inflation spike of 2022, equities have ‘forgotten’ that they should be priced for higher real yields…resulting in the chart below, which I call the “Real Equity Risk Premium” of expected equity returns minus TIPS real yields.
Some of you will say “that’s a trend. Let’s get on that and buy stocks.” To me, that sounds like the fellow falling out a window on the 29th floor and declaring as he passes the 6th floor ‘so far, so good.’ The point of the chart is that when you buy stocks now, you should be expecting to lose money, in real terms, over the next decade. Maybe you’ll average 3% and inflation will be 4%, for example. But TIPS will guarantee you will make 2.25% after inflation. As this spread gets more and more tilted against stocks, it gets harder and harder to explain why anyone would choose equity risk over TIPS risk, other than as a diversifier.
[1] This is not wholly unique to the UK. US 10y inflation bonds have higher real yields than linkers in Australia, Italy, Israel, Canada, France, the UK, Germany, and Spain.
[2] This is wonky stuff. If the expected forward price level doesn’t change, then the breakeven needs to go up because we are starting from lower and lower current price levels due to the (short) lag between the reporting of CPI and its realization in the carry of TIPS. If you don’t understand this because you’re not a rates strategist, don’t worry about it and take my word for it.
