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The Dollar – Best House on a Bad Block
I’m here to draw your attention to something alarming happening in currencies at the moment. Here is a picture of the US Dollar, which has lost a huge amount of value in the past year.
Now, before certain ones of you get all excited and say that this proves Trump is ruining the dollar and forcing foreigners to vamoose out of the United States, take a look at the Euro.
I’m not going to tease you too much with this. The first chart is just the dollar in terms of ounces of gold; the second is the Euro in terms of ounces of silver. Don’t worry, longtime readers: I’m not about to go all gold-bug on you. I could have done those charts with almost any currency against a wide variety of commodities: the Bloomberg Commodity Index is up 23% since mid-August, and +12% since the end of the year. So this isn’t just a precious metals story, and it isn’t just a dollar story. It’s a fiat currency vs ‘stuff’ story.
The recent breathless coverage of the melt-up in precious metals seemed to me to miss the bigger point of what it means. It’s awesome if you’re long precious metals. But the abrupt turn vertical is – or should be – alarming. But nothing looks alarming when it’s pointed higher.
Treasury Secretary Bessent, as I write this, just came out and stated that the United States has a strong dollar policy and has not intervened (at least not yet) to push the dollar lower against the yen. That’s all very nice but I don’t worry a lot about the level of the dollar against other currencies in the medium term and here’s why.
Let’s look at the monetary pipes, which to me imply an increase in the dollar and/or a sharp increase in long-term interest rates regardless of what happens to overnight policy rates. (Many people are concerned about long-term rates because of some vague sense that we are borrowing too much or because everyone is going to sell their US bonds – to buy what with the dollars they receive, no one seems to mention – but there is a mechanical/accounting relationship could cause that outcome).
To this end, the illustration below (Source: Enduring Investments[1]) is a helpful visual guide. For this analysis we are interested in the flows of the dollar system, more than its stock. And the important flows are – or have been – pretty stable. The US has for a long time run a substantial budget deficit, which means the government needs to source dollars by borrowing them. The three sources of those dollars have historically been foreign investors, the Fed, and domestic savers. Foreign investors have extra dollars because the trade deficit means that Americans send more dollars to foreign producers than foreign consumers send to US producers, and those extra dollars are invested in the US into government bonds (spigot on the lower left) or otherwise invested in markets or direct investment (spigot on the lower right). The Fed balance sheet, over the last decade or so, has often been a supplier of dollars to the system when it has been expanding more often than not. Finally, there are domestic savers who buy Treasury bonds among other things (but consider that when they’re buying US stocks, for example, the dollars are just sloshing from one domestic saver to another – that’s why there’s no flow shown for domestic savers buying US stocks). Those three ‘suppliers of dollars’ are the top hoses filling up the barrel of dollars in the illustration below.
Those flows tend to reach stasis via automatic stabilizers. For example, if the government is draining more money (with a big budget deficit) than is being supplied elsewhere, then either interest rates rise to induce domestic savers to provide more money, or the trade deficit expands. My concern is that automatic stabilizers tend to take time to stabilize, and currently there are some big changes. See the next illustration and focus on the differences compared with the prior one.
The cessation of the expansion of the Fed’s balance sheet has been happening for a while, and the balance sheet has even been shrinking a little. But the Trump Administration’s trade policies have caused two major changes: first, the trade deficit has been shrinking sharply (see charts below, source Bloomberg; the first shows the net trade balance monthly and the second shows the recent trends of declining imports and rising exports).
Some of this may be ‘payback’ for the surge in imports at the beginning of the year by importers trying to beat the imposition of tariffs, but there seems little question now that the trade deficit really is closing substantially. At the same time, foreign companies have been tripping all over each other to start making substantial investments into the US. In the second ‘barrel of money’ chart above, note the spigot at the lower right is really gushing, and two of the hoses supplying dollars have slowed to a trickle or stopped.
If that’s a fair representation, then what are the implications? If those trends persist, then the demand for dollars is going to outweigh the supply of dollars, leading to two outcomes. One of those is that in order to induce more dollars to fund the federal deficit, interest rates will have to rise. The Fed can control the policy rate, but in order to keep long-term rates down the Committee may eventually be forced to start up their hose again – intervening to buy Treasuries in the market to prevent long rates from rising, and expanding the balance sheet. The market stabilizer here would be for interest rates to rise and induce more domestic savings; if for policy reasons the Fed doesn’t want that then they’ll have to add more money themselves, with inflationary consequences. (It’s inflationary either way, but if interest rates rise it’s only indirectly inflationary in that higher interest rates also increase money velocity).
The other implication is that the dollar would strengthen on foreign exchange markets, since if foreigners are going to invest in the US in financial markets (or with direct investment, building new plants and so forth) they will need dollars to do so and the trade deficit is no longer providing a surplus of those dollars. It’s likely also that, with fewer dollars being sent abroad, domestic stock and bond markets would struggle more than they have been. A stronger dollar would be disinflationary at the margin, helping to hold down core goods prices, but this effect is fairly small…especially in the broader context I’ve mentioned, which is that all fiat currencies right now are getting smashed versus real stuff.
These are the implications of the recent large changes in financial flows. There are potential offsets available. If the trade deficit declines and the federal budget deficit declines also, it diminishes upward pressure on interest rates since domestic savers do not have to be incentivized to provide as much of the dollars in deficit. You can infer this from the barrel illustrations as well: if the federal budget moves towards balance, it lessens the net change in the system.
And there had been some positive signs on that score. The tariff revenue has been large, and some of the spending priorities of the prior Administration have been de-emphasized. These are positive developments which could lessen the pressure on the dollar and interest rates…except that the Trump Administration has been mooting the idea of ‘tariff dividend checks,’ increased defense spending, buying Greenland, and other significant spending initiatives.
It is also possible, even probable, that the Fed or Congress could change banking liquidity regulations in such a way that banks are forced to hold more Treasuries, which would add an additional hose to the top of the barrel. However, the more assets that banks are required to hold, worsening the return on assets of traditional banks, the more banking functions will start to move to non-bank entities or into crypto, increasing the money supply while decreasing the Fed’s control of it.
The upshot of all of these changes is that – based on the flows as we see them now, which could change – I believe we are going to see a significantly steeper yield curve and a significantly stronger dollar over the next few years.
Having said all of that, let me circle back to the start of this note – while the USD is not likely to collapse against other currencies, the movement against commodities (not to mention equities) and other real assets is disturbing. The US money supply has been accelerating recently; M2 is only +4.6% in the last 12 months, but that’s near (or may even be above) the maximum rate that is sustainable without causing inflation in a country that is deglobalizing and in demographic reverse. I am not bullish on gold and silver at these levels, and am more cautious on commodities than I have been in a while. But while I am a dollar bull against other currencies, I am a bear of fiat currencies against real assets generally…and I am concerned that the recent waterfall-like behavior of fiat presages a re-acceleration of CPI-style inflation. Commodities feed broadly into prices, but so do wages and lots of other things that are measured in terms of dollars. If the problem is fiat, and not gold and silver themselves, then it’s a bullish signal for inflation.
[1] These images were generated using AI image generation tools to create an illustrative representation for explanatory purposes.
Why Hedonic Adjustment in the CPI Shouldn’t Tick You Off
I’ve worked in the inflation field for about a quarter-century (depending on how you want to count it), and I can tell you that if you really want to start a food fight at an investment conference, mention the term ‘hedonic adjustment’ as it relates to the Consumer Price Index. Thanks to substantial counter-programming by people who want you to prefer their narrative on inflation and their inflation index, people who tend to hold to the “the government is making it up” narrative about inflation like to quote hedonic adjustment as one element of proof.
The first problem with this is that people seem to think that CPI is supposed to measure how their actual cash costs change every year. It isn’t. If you look at the price of anything, it represents a trade offered by the supplier of value for value: if you give me X dollars, I will give you the widget that paints your house in 6 hours. If you don’t think that widget is worth X dollars, then you don’t buy the widget.
But widgets change. If the same vendor offers the same widget, but thanks to improvements now will paint your house in 3 hours, and now costs Y dollars, you the buyer have the same evaluation to make except now it’s the value of a 3-hour paint job versus Y dollars instead of 6-hours versus X dollars. If you want to see how the trade changed, then you can’t just compare Y versus X. You have to compare the other side of the trade also. Or, to put it another way, the difference in price (Y-X) isn’t just due to the fact that the dollar is worth less now than it was, so that even the old version of the paint-widget would cost X’, but also because it’s a better widget. You the consumer see the price going up from X to Y, but that consists of inflation X’-X, plus quality improvement of Y-X’.
There are no two ways of looking at that. If you want to measure the change in cash outlays, just count your cash outlays. But if you’re trying to measure the change in the cost of living, then you need to try to hold the standard of living constant between measurements.
So any inflation measurement needs to account for the fact that widgets change, or it will perpetually exaggerate inflation.
Most of those adjustments are pretty straightforward. If your candy bar got 20% smaller, it’s easy to account for the additional inflation that implies. In fact most of these quality adjustments are called “quality adjustments.” It becomes a ”hedonic” adjustment when the widget has a lot of different elements that give it value. Think of a car, where having better fuel efficiency is valuable but so is an improvement in the dashboard entertainment system. When the price of the car changes, it’s much harder to figure out how much of that due to inflation (paying more to get the same stuff, X-X’ in the example above) and how much is due to the change in the components of the vehicle. Enter the econometrician, who applies fancy mathematics that you may be unsurprised to learn is called a ”hedonic regression.”
Now, just about 100% of the CPI basket is subject to quality adjustment when necessary. As I said, quality adjustment is necessary. But only a small fraction of the basket is adjusted using hedonic regression.
But it’s not even as bad as that. You hear a lot of grumbling about how “hedonic adjustment says the price of a computer is falling even though it’s staying the same or going up, so obviously inflation is really higher than the government says it is.” But you almost never hear anyone complain about hedonic adjustment to shelter. The BLS, you see, adjusts for the fact that the housing stock gets older, so that if you pay the same rent from year 1 to year 2 it actually works out to be inflation because you’re getting a slightly older apartment. The real kicker? The upward hedonic adjustment to shelter inflation comes very close to balancing the downward hedonic adjustment to computers and microwaves and things. In other words, if you outlawed hedonic adjustment it wouldn’t really change the CPI hardly at all. A 2006 paper by Johnson, Reed, and Stewart found that the “net effect of hedonics from 1999 onward…is estimated to be less than 1-hundredth of 1 percent per year, specifically +0.005 percent.”[1]
So honestly, the bottom line is that people yell about hedonic adjustment for the same reason they yell at referees. They have to yell at something when they don’t like the outcome!
Is hedonic adjustment “right?” That is, does it correctly determine how much of a price change is due to inflation and how much is due to quality changes? I can say with great certainty that it is not exactly right. It’s an estimate. Virtually every financial model is an estimate. The Black-Scholes option pricing model isn’t right either – in fact, we know that the Black-Scholes model isn’t just wrong, but it’s wrong in some very systematic ways. And yet, people continue to use Black-Scholes, because we understand the ways in which it’s not right and can adjust for it.[2]
Hedonic adjustment is also not “right.” But it’s a fair approach, and if you want to adjust the CPI by removing the downward hedonic adjustments while keeping the upward hedonic adjustments (to shelter) then you can make that adjustment mentally by just adding about +0.10% per annum to the CPI. Either way…it shouldn’t tick you off.
[1] Johnson, D.S., S.B. Reed, and K.J. Stewart. 2006. “Price Measurement in the United States: a Decade After the Boskin Report.” Monthly Labor Review (May): 10–19.
[2] One big way is that since actual market movements aren’t distributed normally, and the Black-Scholes model assumes they are, the price of options that are far out-of-the-money are systematically low. Or they would be, if we didn’t adjust for this known problem by applying a volatility smile to price out-of-the-money options.
Inflation Guy’s CPI Summary (September 2025)
Well, it seems like it’s been a while since the last CPI update! Thanks to the government shutdown, it has been since this data is a week and a half later than it was scheduled to be. The importance of the CPI release is obvious, but it was reinforced by the fact it’s the only one the government is calling people back to release. It isn’t that we don’t have reasonably-accurate alternative ways to measure price pressures, though – it’s because unlike Payrolls and most other government releases that are important touchpoints for economists, the CPI is an important legal touchpoint for contracts, bonds, and legal obligations of the federal government. In this case, September’s data is a crucial number needed to calculate COLA adjustments for Social Security for next year. If this had been October’s data? I’m not sure they call back workers to release it. But that’s next month’s problem.
Speaking of next month’s problem: the government shutdown did not affect data gathering for this month’s number; they had to recall the people to collate the data and publish it but not the collectors. So the quality of the data should be fine. The data-quality question is much murkier when we look forward to next month, but since much less of the data collection is done by guys with clipboards these days, it might not be as bad as you think. Still, that will be the concern for the October CPI released next month. Like I said: next month’s problem!
Heading into the release, consensus was for +0.37% on headline CPI (SA) and +0.29% on core. I have to admit that I was confiding to people that this seemed sporty because the prior month had seen a surprising acceleration in rents that could be reversed, indications are that Used Cars would be a drag, and Food at Home also looked soft (I was right on 2 out of 3 – Food at Home was an add). That told us going in that if we were going to get to +0.29% core, either I had to be wrong on most of that or core goods ex-used cars was going to have to be pretty strong. Tariffs definitely are helping to push that narrow group of the consumption basket higher. But is that enough? Let’s see.
The backdrop going into the data was that rates have been generally softening, and the inflation swaps curve has been steepening (lessening its inversion, with near-term inflation pricing dropping more than longer-term inflation expectations). That’s consistent with a return to normalcy…but it’s really happening because energy prices have dropped quite a bit until the last couple of weeks, and that has a more immediate impact on the front of the inflation curve. The mean reversion time for energy prices is something like 15 months, so by the time you’ve gotten a few years out the curve today’s lower gasoline prices shouldn’t much affect your expectations of inflation forwards. But it affects inflation spot, which propagates through the forwards.
Actual print: SA CPI +0.31%; SA Core +0.227%. Softer than expected, and it took only a moment to see that a big part of that was due to a sharp deceleration in Owners’ Equivalent Rent (see chart). Some of that was the give-back I expected, but it was more than that and so we should put this in the back of our minds for next month – we’re probably due a reversal in the other direction over the next month or two.
Interestingly, even with the miss the Core CPI time series doesn’t look terribly weak. I mean, +0.227%, repeated for a year, still gives you 2.7% core CPI. And we won’t get downside drags from cars and housing every month.
Interesting jump in apparel this month. It’s a small category and always volatile, but since we also import almost all of our apparel it’s one place I look for tariff effects. But note the y/y numbers are still very low and in fact decelerated with this jump, implying last year’s bump in September was even larger. That’s a seasonally-adjusted figure, but I wonder if the problem here is that seasonal adjustment is failing us. Maybe pre-holiday mark-ups (from which we can show great discounts in a month!) are happening earlier. In any event it’s only 2.5% of the CPI so probably not worth too much computational cycles.
Core goods inflation rose slightly to +1.54% y/y, and core services declined to 3.47% y/y. The latter is mostly and maybe entirely due to housing, which is a core service. The former is interesting because Used Cars/Trucks was -0.41% m/m. That was expected, but it means that other core goods were more buoyant.
So here are OER and Primary Rents. 3.76% y/y (only +0.13% m/m) and 3.4% y/y (only +0.2% m/m). You can’t really tell a lot about the miss today from this chart – I showed the m/m series earlier, and the bottom line is that this continues to level out. I think the flattening is going to be more dramatic over the next 3-6 months but we’ll see. Lodging Away from Home rose again, +1.3% m/m, and is now flat y/y.
At this point, I’m thinking: with rents a downside surprise and Used Cars a downside surprise, this isn’t that bad a miss. In other words, if you’d told me we were going to get those numbers from rents and cars I would have thought core would be a lot weaker than +0.23% m/m.
Earlier I showed the last 12 Core CPIs. My guess at Median looks better, but that’s mostly because the median category is West Urban OER and even split up, an aberration in OER – and that’s what I think this is – is enough to sway Median CPI. It also means my estimate of median, +0.213% m/m, might be off because the Cleveland Fed separately estimates the seasonals for the regional OERs and so I have to guess at that part. My guess will take y/y Median CPI to 3.5% from 3.6%. And the Fed is easing. Hmm.
Here are the four-pieces charts. Food and Energy +2.99% y/y. Core Commodities +1.54%. Core Services less Rent of Shelter (Supercore) +3.37%. Rent of Shelter +3.53%. These are the four pieces that add up to CPI. None of them looks terrible except for Core Goods, and there’s limited upside to that – and it has a short period, so in a year it’s likely to be lower. I do think that going forward, core goods remains positive instead of the steady deflation it was in for decades, but not big positive. However, you need it to be negative if you want inflation at 2%, unless you get core-services-ex-rents a lot lower (but that’s highly wage-driven, and reversing illegal immigration helps support that piece somewhat) or rent of shelter a lot lower. The latter is certainly receding but it’s not going to go a lot lower.
I don’t usually spend a lot of time talking about energy, because that’s a hedgeable piece (largely – gasoline is a big part of energy and that’s easy to hedge with a little lag; electricity is harder). This month, Energy was +0.12% NSA. But next month, we’ll see a decent drag because of the sharp drop in gasoline over the last few weeks. That’s a little early compared to the usual seasonal, and it may mean we get the usual December drop in gasoline in October CPI.
Except…that I think the White House has teased that we might not get October CPI at all, just skip it, because of the difficulty gathering data. If that is true, the fallback mechanisms will kick in. See my piece on what that means, here, but the bigger point is that you wouldn’t get my scintillating commentary. I guess again that’s not this month’s problem.
Now, I have to show this almost by habit, and because the economists expecting housing deflation will be dancing in the streets. Take pictures, and show them again next year. They never learn. Housing inflation is slowing but there is no sign rents are going to come anywhere near deflation. Except maybe on a weighted basis if Mamdani gets elected Mayor of New York City and freezes rents. But then we’ll have to start looking rents ex-NYC.
How disinflationary a period are we in? Wellllll…of the item categories in the median CPI calculation, there were zero core categories that decelerated faster than 10% annualized over the last month (-0.833% or faster). On the plus side, there were Personal Care Services (+11.9% m/m annualized), Footwear (+12.0%), Motor Vehicle Fees (+14.2%), Tenants’ and Household Insurance (+15.2%), Lodging Away from Home (+17.5%), Miscellaneous Personal Goods (+17.9%), Men’s and Boys’ Apparel (+19.3%), and Public Transportation (+21.5%). These are small categories for the most part – but not all import goods and interesting in that the tails are all to the upside. That’s not the way a disinflationary economy usually looks, although I don’t want to overstate the importance of a single month!
Here’s the observation about long tails compressed into a single number, the Enduring Investments’ Inflation Diffusion Index. It’s signaling upward pressure.
Below is a chart of the overall distribution. The two big spikes in the middle are mainly rents and OER. But take those away and you can see there’s not a lot of categories in the 1-3% range, and a decent weight in the 5-6% range. This doesn’t really look like a price system settling back down placidly to 2%.
Now, the stock market clearly loves this, which makes sense. The Fed is going to ease, probably twice more this year. But that was already baked into the cake in my mind, because the Fed no longer targets 2% inflation. Remember that in the most-recent change to the 5-year operating framework the Fed, in Chairman Powell’s words, “…returned to a framework of flexible inflation targeting and eliminated the ‘makeup’ strategy.” I talk more about that here: https://inflationguy.blog/2025/09/02/the-fate-of-fait-was-fated/ Ergo, the Fed doesn’t really care if we get to 2%. They’d prefer to not see inflation head higher, but they can spin a story to themselves that even though median inflation is in the mid-to-high 3s, “the process of inflation anchoring is underway” or somesuch nonsense. As long as it’s not hitting them in the face that inflation is going up, they’ll keep relying on their models that say it should be going down. N.b., those are the same models that said inflation shouldn’t have gone up that much to begin with, and should have been transitory, but we all know “Ph.D.” stands for “Pile it higher and Deeper.”
Eventually, inflation going up probably will hit them in the face. But that’s such a 2026 problem.
The Fault, Dear Brutus, is in R*
I want to say something briefly about the “neutral rate of interest,” which has recently become grist for financial television because of new Trump-appointed Fed Governor Stephen Miran’s speech a couple of days ago in which he opined that the neutral rate of interest is much lower than the Fed believes it is, and that therefore the Fed funds target should be more like 2%-2.25% right now instead of 4.25%.
Cue the usual media clowns screaming that this is evidence of how Trump appointees do not properly respect the academic work of their presumed betters.
If that was all this is, then I would wholeheartedly support Miran’s suggestion. Most of the academic work in monetary finance is just plain wrong, or worse it’s the wrong answer to the wrong question being asked. And that’s what we have here. Anyone who thinks that Miran is an economic-denialist should read the speech. It is mostly a well-reasoned argument about all the reasons that the neutral rate may be lower now than it has been in the past. And I applaud him when he comments “I don’t want to imply more precision than I think it possible in economics.” Indeed, if we were to be honest about the degree of precision with which we measure the economy in real time and the precision of the models (even assuming they’re parameterized properly, which is questionable), the Fed would almost never be able to decisively reject the null hypothesis that nothing important has changed and therefore no rate change is required!
I can’t say that I agree with Miran’s argument though. Not because it’s wrong, but because it’s completely irrelevant.
Sometimes I think that geeks with their models is just another form of ‘boys with their toys.’ And that is what is happening here. The “neutral rate of interest” is a concept that is cousin to NAIRU, the non-accelerating-inflation rate of unemployment. The neutral rate, often called ‘r-star’ r* (which is your clue that we’re arguing about models), is the theoretical interest rate that represents perfect balance, where the economy will neither tend to generate inflation, nor tend to generate unemployment. Like I said, it’s just like NAIRU which is a level of unemployment below which inflation accelerates. And they have something else in common: they are totally unobservable.
Now, lots of things are unobservable. For example, gravity is unobservable. Yet we have a very precise estimate of the gravitational constant[1] because we can make lots of really precise measurements and work it out. Economists would love for you to think that what they’re doing with r* is similar to calibrating our estimate of the gravitational constant. It’s not remotely similar, for (at least) two enormous reasons:
- Measuring the gravitational constant is only possible because we know (as much as anything can be known) what the formula is that we are calibrating. Fg=Gm1m2/r2. So all we have to do is measure the masses, measure the distance between the centers of gravity, and infer the force from something else.[2] Then we can back into G, the gravitational constant. Here’s the thing. The theory of how interest rates affect inflation and growth, despite being ensconced in literally-weighty economics tomes, is just a theory. Actually, several different theories. And, by the way, a theory with a terrible record of actually working. To calibrate r*, the hand-waving that is being done is ‘assume that interest rates affect the economy through a James and Bartles equilibrium…’ or something like that. It is an assumption that we shouldn’t accept. And if we don’t accept it, calibrating r* is just masturbation via mathematics.[3]
- With the gravitational constant, every subsequent measurement and experiment confirms the original measurement. Every use of the model and the constant in real life, say by sending a spacecraft slingshotting around Jupiter to visit Pluto, works with ridiculous precision. On the other hand, r* has approximately a zero percent success rate in forecasting actual outcomes with anything like useful precision, and every person who measures r* gets something totally different. And r* – if it is even a real thing, which I don’t think it is – evidently moves all the time, and no one knows how. Which is Miran’s point, but the upshot is really that monetary economists should stop pretending that they know what they’re doing.
In short, we are arguing about an unmeasurable mental construct that has no useful track record of success, and we are using that mental construct to argue about whether policy rates should be at 2% or 4%. Actually, even worse, Miran says that the market rate he looks at is the 5y, 5y forward real interest rate extracted from TIPS. The Fed has nothing to do with that rate. But if that’s what he is looking at why are we arguing about overnight rates?
I should say that if there is such a thing as a ‘neutral rate’ that neither stimulates nor dampens output and inflation, I would prefer to get there by first principles. It makes sense to me that the neutral long-term real rate should be something like the long-run real growth rate of the economy. And if that’s true, then Miran is probably at least directionally accurate because as our working population levels off and shrinks, the economy’s natural growth rate declines (unless productivity conveniently surges) since output is just the product of the number of hours worked times the output per hour. But I can’t imagine that the economy ‘cares’ (if I may anthropomorphize the economy) about a 1% change in the long-run real or nominal interest rate, at least on any time scale that a monetary policymaker can operate at.
The best answer here is that whether Miran is right or not, the Fed should just pick a level of interest rates…I’m good with 3-4% at the short end…and then change its meeting schedule to once every other year.
[1] Which may in fact not be constant, but that’s a topic for someone else’s blog.
[2] In the first experiment to measure gravity, which yours truly replicated for a science fair project in high school, Henry Cavendish in 1797 figured the force in this equation by measuring the torsion force exerted by the string from which his two-mass barbell was suspended, with one of those masses attracted to another nearby mass.
[3] Yeah, I said it.
Inflation Guy’s CPI Summary (August 2025)
Before I begin talking about today’s CPI, a quick word about the 24th anniversary of the terrorist attacks of 9/11. As someone who worked 1 block from the Towers, I can tell you it’s a day I will never forget and filled with images I can never erase. But I also remember that in the weeks that followed, the country was unified in a way I’d never seen. Rudy Giuliani was “America’s Mayor” for his courage and steady hand during the disaster and in the period that followed. When I traveled to the Midwest, menus were filled with ‘Freedom Fries’ and strangers asked with concern about my family and friends when they heard I was from New York. It seems crazy to me that only 24 years removed from that, the country is divided in a way I’ve never seen. Everyone said “we will never forget.” And then they forgot.
But I do not forget. I give prayers and thanks for the brave first responders I saw that day and for the families of those who didn’t return. And you should too.
All of which makes the monthly CPI report seem very small. In truth, it is small all of a sudden. From being one of the most-important releases for a couple of years because of the Fed’s assumed reaction function, it has abruptly been pushed to the back. This is partly because of the weak Employment data and the massive downward revisions to the prior data but that point is reinforced by the Fed’s recent adjustment to the inflation targeting framework, in which they removed any imperative to make up for periods of high inflation by engineering lower inflation so that the reaction function is basically one way. (See my writeup on this at https://inflationguy.blog/2025/09/02/the-fate-of-fait-was-fated/.) I guess there’s an ironic parallelism here. After the inflationary 1970s and the pain of bringing inflation back down, the Fed said “we will never forget.” And then they forgot.
But I do not forget. And neither should you. An investor’s nominal returns are irrelevant (except to the IRS). What matters is real returns, and a period of higher and less-stable inflation has historically resulted in lower asset prices since the most important indicator of future returns over normal investing horizons is starting price. If markets need to adjust to higher inflation to give higher nominal returns, the easiest way to do that is to lower the starting price. So whether the Fed cares, we should.
And with that – we came into today with real yields having fallen some 20bps this month, but with inflation expectations having not declined much at all. Obviously, that’s the market’s reaction to the presumed tilt of the Fed.
The CPI report was slightly above expectations, which were already somewhat higher than in prior months. So when people tell you this was a ‘small miss higher,’ that’s mainly because economists adjusted their expectations, not because the number was similar to prior months. Month/month headline inflation (seasonally adjusted) was +0.382% (expectations were +0.33%), with core at +0.346% (expectations were +0.31%). Markets have not reacted poorly to this figure, but I wonder if core had been slightly higher and rounded to +0.4% if we’d have seen more introspection.
But as I said, this is a ‘small miss’ but that does not mean it was a small number. Indeed, with the exception of the jump in January associated with tariff noise, this is the highest core figure in 17 months.
There were a number of upside categories, but one of them was not Medical Care. Some people had been looking for a move higher here, and Doctor’s Services rose a bit, but Medicinal Drugs fell -0.372% m/m and is now down year/year. That surprises me, but there are a lot of pressures on the drug industry right now and it is going to take a while to see how it shakes out.
Core goods prices continued to accelerate. On a y/y basis, core goods are +1.54%. With the exception of the COVID spike, this is the highest level of core goods inflation since 2012. Some of that is definitely due to tariffs, and that will trickle in for a while. But the long-wave concern is that deglobalization/re-onshoring of production means that it will be very hard to get core goods inflation back to the persistent mild deflation we had enjoyed for a very long time. And without that, it is very hard to get core inflation to 2%, especially if core services (+3.59% y/y) stops improving as the chart sort of hints it might.
One surprise you will hear a lot about is Owners Equivalent Rent, which was +0.38% m/m. Primary Rents were +0.30% m/m. Both of those are higher than the recent figures, but this looks like some residual seasonal-adjustment issues to me. The y/y for both continues to decline, albeit at a slowing rate, which means that the number we dropped off from last year was higher than the upside surprise of today.
Rents are on schedule.
We also saw another jump from airfares, +5.87% m/m, and Lodging Away from Home (+2.92% m/m) finally rebounded after months of weakness. Used cars were +1.04% m/m, and new cars +0.28%. When you look at all of the pieces, it adds up to Median CPI being almost the same as last month: my early guess is +0.276% m/m.
Turn that picture any way you want to. I don’t see a downtrend.
When we break down inflation into the four main pieces, none of them is in deflation and none seems to be an overt drag or pulling everything else up. Food and Energy is +2.16% y/y. Core goods is +1.54% y/y. Core services less rents (aka Supercore, chart below) is +3.56% y/y. And Rent of Shelter is +3.61%. How do you want to get inflation to 2% from those pieces?
Long-time readers will know this does not surprise me. Median CPI will be around 3.6% y/y again. That’s where we are. We overshot my ‘high 3s, low 4s’ target to the downside a bit, but we’re back up in the mid-to-high 3s. I’ll take that as a win.
I want to share the money supply chart. On an annualized basis, we’re near 6% y/y over the last six months. That is back to pre-COVID levels, and is too fast in this environment. You can’t get 2% inflation with deglobalization and sour demographics if you’re running the monetary playbook from when you had globalization and positive or neutral demographics.
And finally, we now know USDi’s price through the end of October.
So what does all of this mean for policy? Well, see what I said above about inflation targeting and the change of the Fed’s operating framework. The most important things to the FOMC right now are, in order:
- Employment
- Politics, and jockeying for position to be named next Fed Chair
- Internal modeling about tariffs, inflation expectations, rents, etc.
- Actual inflation numbers, like CPI
35th or so in importance is “the quantity of money,” if it’s on the list at all. You can probably glean from my list that I think the Fed is likely to ease. Let me make clear that I do not think that a wise Fed chair would even consider easing with median inflation steadying around 3.6%, and a 50bps cut would be laughable. However, this is not a wise Fed chairman, and this one is going to ease. In my gut, I think the Fed will cut 25bps but with several dissents for 50bps. I would not be shocked with a 50bps ease even though it is completely boneheaded to do it with inflation still running hot with no clear path for it to decline to what used to be the target.
But that’s the point I suppose. Is there even a target, if the Fed doesn’t mind missing it?
One final announcement. If you’re an investor in cryptocurrencies (in particular, stable or flatcoins) and have a Telegram account, consider joining the read-only USDi_Coin room https://t.me/USDi_Coin where the USDi Coin price is updated every four hours or so…and where many of these charts are also posted shortly after CPI just as I used to do on Twitter.
The Fate of FAIT was Fated
Growth in the US is ebbing, and it is likely only the AI boom that is keeping us from recording a small recession. Unemployment is still rising, although slowly, and credit delinquencies are rising. Because the services sector and the goods sector are still asynchronous – a holdover from the COVID period – we haven’t seen an aggregate contraction, but it will happen eventually. That doesn’t concern me. Recessions happen. It is only worrisome because equity markets are so ‘fully valued’ that an adjustment to a recession could be rough. On the other hand, all signs point to the Federal Reserve starting to ease, and this may support stocks. I would go so far as to say that investors are counting on that.
That is a rather ordinary problem. The bigger problem has not yet been realized by equity markets, but as we look at long maturities on the yield curve we see that yields are near the highs of the year even with the Fed expected to ease. That is not normal. When the Fed eases the curve tends to steepen, because however long the period of lower short rates, it will be a larger proportion of a shorter-maturity instrument. But long rates still decline in that case, normally.
You can insert your favorite story here, about how foreign investors hate Trump, or people are worried about inflation, or the credit profile of the United States. My preferred explanation (see “The Twin Deficits – One Out of Two IS Bad”) is that if you reduce the trade deficit sharply but do not reduce the budget deficit equally sharply, then the balance must be made up by domestic savers and that implies a higher rate of interest.
There’s also some reason to be wary of the turn higher in inflation, even though that was entirely foreseen (see “Ep. 145: Beware the Coming Inflation Bounce”) and a good part due to base effects. There are, though, some signs of underlying secular rather than cyclical pressures on prices. For example thanks partly to AI electricity prices started accelerating higher in 2021 but unlike other parts of the CPI have continued to rise. The CPI for Electricity stands 35% above the level of year-end 2020, and well beyond the long-term trend. Beef prices are 41% higher and still rising.
Of course, there are always prices that are rising but there are two reasons I am more concerned about this now. The first is that the money supply has returned to a positive and rising growth rate and is at a level inconsistent with long-term price stability even before the Fed renews its easing campaign.
Five percent was once a nice level for M2 growth, when demographics and globalization were following winds. Now they are headwinds and we need to be lower. Still, I wouldn’t get panicky about 5%. Get to 8% and I’ll be more concerned. But the reason that might happen concerns changes happening at the central bank.
What gets the headlines is the continual pressure that the Trump Administration is putting on Fed Chairman Powell and others on the Federal Reserve Board, several of whom are jockeying to be dovish enough to be selected as the next Fed Chair. But the much more important development was the 5-year review of the Fed’s operating framework, which Powell discussed at his Jackson Hole speech. The significance of this was seeming lost on most investors, although 10-year breakevens have gradually risen and are up at 2.42%, and other than in the post-COVID surge they’ve not been much higher than that since 2012 or so.
These are 10-year breakevens, so this isn’t a tariff effect. What’s going on here? Not much, yet, but…there is the change in the Fed’s framework, which I think is important.
Five years ago, the Fed abandoned a specific inflation target in favor of “Flexible Average Inflation Targeting”, or FAIT, which basically said “we are targeting 2% inflation, but only over time. So when inflation is too low for a while, then it’s okay to let it run hot for a while later.” At the time, this was a clear sign that monetarists – who don’t necessarily believe there is a tradeoff between inflation and growth like the Keynesians do – were losing the battle. More flexibility to respond to inflation ‘tactically’ is not something that we needed, and it wasn’t clear how that would be a helpful change anyway.
But the current 5-year framework adjustment is worse. It basically abandoned the good part of FAIT, which was any kind of soft commitment to be hawkish in the future if necessary. In Powell’s words – and I’m not making this up – “…we returned to a framework of flexible inflation targeting and eliminated the ‘makeup’ strategy.”
Yep, that’s what he said.
There is a lot more in Powell’s explanation, but most of it all leans in the same direction. For all my historical criticism of former Chairman Greenspan, he deserves credit for this: he used to say that achieving low and stable inflation was key to achieving maximum stable employment over time. Thus, inflation was primary, not secondary, in achieving the dual mandate. Now, the Fed ostensibly wants to target a low level of inflation…because that’s what central banks are supposed to do…but recognizes that sometimes they’ll want to emphasize lower rates to help Employment – and the important part is that as I just noted, they won’t ‘make up’ for running too much liquidity now by running less liquidity later. Does anyone want to take the other side of the bet that the Fed will have an easier time lowering rates and keeping them low, than raising them and keeping them high? Accordingly, the long-term inflation outlook just got worse. I don’t think we are returning to the 1970s, but we aren’t returning to 2% any time soon – and the Fed is okay with that!
FAIT was never a very good idea, and I didn’t think it would survive the first time inflation ran too high and dictated an extended period of very tight money. It didn’t. I didn’t think they’d actively make it worse, and maybe the joke’s on me. They always make it worse.
Inflation Guy’s CPI Summary (April 2025)
Before the CPI analysis, I always try to give some context for where we are in the ‘story’ about the evolution of inflation right now. It’s really difficult to do that, though, because of all of the massive policy changes that are happening – and often in opposite directions with respect to the effect on inflation. Here is the Baker, Bloom & Davis Economic Policy Uncertainty Index, which is derived by scraping news sources. Even strong supporters of President Trump’s have to admit that his Administration has been a whirlwind on economic policy (for many of them, of course, that’s a feature and not a bug).
Here goes, anyway. Remember that last month, core CPI crashed but Median CPI actually accelerated. This kept us from actively celebrating the great inflation news; we knew that the good news was concentrated in a few one offs. In particular, Airfares (-5.3% for March), Lodging Away from Home (-3.5%), Used Cars (-0.69%), Car and Truck Rental (-2.66%), and Medicinal Drugs (-1.30%). But, as Median showed last month, there was really no reason to think that inflation was behind us…even before any effect from tariffs.
Speaking of tariffs, prior to this month we hadn’t really expected to see any effect yet and most economists thought that we shouldn’t see that much impact in the April figures either since the big tariffs on everyone went into place early in that month. However, remember that Mexico, Canada, and China had all faced escalating tariffs prior to April, so if there is going to be an impact we should expect to see something soon. I don’t expect a lot in most categories, but some impact in a few. It will be hard to discern how much of any monthly price change is tariffs, of course. We will look at Apparel, where demand elasticity in the short run is not terribly low. Broadly, though, remember that demand elasticity and foreign content percentage are both important…and foreign content in most goods is pretty low. I’d also look to Medicinal Drugs, since a lot of APIs are China-sourced and the demand for many drugs is pretty inelastic in the short-run, but I didn’t expect a lot of impact there (pharma companies will have had inventories), and going forward it will be muddied by Trump’s announcement of the Most-Favored-Nation policy in pharmaceuticals.
Speaking of that announcement, this month’s review of changes in inflation swap levels is seriously polluted because that announcement combined with the 90-day pause on China tariffs caused a massive crash in 1-year inflation expectations.
Despite the drop in tariff rates on China (for now), remember average tariffs remain the highest since the Great Depression (ominous music)! Of course, back then the US was a significant net exporter, so reciprocal tariffs were a bigger problem. Imports were only about 2-3% of GDP.
(Chart above is from https://www.stlouisfed.org/on-the-economy/2019/may/historical-u-s-trade-deficits)
(Chart above is from https://www.stlouisfed.org/on-the-economy/2020/march/evolution-total-trade-us)
There you go. That’s the context. Now onto the number.
CPI for April was expected to be +0.25%, and +0.27% on Core. The actual prints were 0.221% and 0.237%, respectively, so a mild surprise lower (although it turned the +0.3%/+0.3% rounded expectations to +0.2%/+0.2%, looking more dramatic a surprise than it actually was). Core is right about where it has been for the last 6 and 12 months (0.244% and 0.229% average, respectively) with the big January spike and the March plunge basically offsetting each other.
Amazingly, of the eight major subgroups only Housing, Medical Care, and “Other” increased on a m/m basis. What is especially surprising in that light is that Apparel – where the tariff canary in the coal mine lives – was down on the month.
Core goods continues to hook higher, now at +0.13% y/y. Remember, this is before any tariff effect has really been felt. In my mind, this is more the underlying ‘deglobalization’ effect: as I’ve said for a while, the deep deflation in core goods that we saw was a partial retracement of the COVID spike and we should expect going forward to see a small positive inflation in goods. Core services is decelerating nicely, and it will need to continue to do that if we’re ever going to see downward pressure in median inflation from where we are now.
Speaking of Median CPI, my early estimate is +0.308% m/m, putting the y/y at 3.43%. That’s about where we’ve been, and where we’re likely to be going forward.
Looking at some of those one-off categories from last month, Airfares fell another -2.83% m/m after that -5.3% prior decline. Some of that is jet fuel, some is tourism I suspect. Lodging Away from Home went flat (-0.1% m/m) from -3.54% prior. I think we’ll see continued downward pressure in that category, as hotels in some big cities are gradually emptied of illegal migrants and get added back to the stock of available rooms, but March’s drop was just too big. Used Cars’ decline (-0.53%) surprised some people, because the private surveys showed that prices advanced last month, but the seasonal assumption was a decent hurdle this month that wasn’t cleared. However, if you were worried about how the spike in car parts tariffs would cause car prices to spike…because that’s what the news was hyperventilating about…you needn’t have. New Car prices were also slightly down, -0.01% compared to +0.1% last month.
As for shelter, it continues to flatten out, with Primary Rents 3.98% y/y and OER at 4.31% y/y. Actually, Primary Rents were flat on a y/y basis compared to the prior month, and have basically converged with our model, which is around 3.7%. From here we should expect very slow deceleration, but rents should stay above 3.25% or so on a y/y basis.
Supercore is looking great. This is about the best news in the report, because if Shelter is just about tapped out and Core Goods is trending just above zero we’d need Core Services to continue to dive.
That’s the good news. The bad news is that the spread of median wages over median prices has returned to its long-run average, which means that it will be hard to see additional sharp declines here…it isn’t going to come from squeezing wages further.
Outright, the Atlanta Fed Wage Growth Tracker – the best measure of wages in my opinion – is at 4.3% y/y. That’s right where it was in November. It’s going to be very hard to squeeze services prices lower if wages don’t decelerate further.
Finally, let’s circle back to pharmaceuticals. I’m going to point you again to my article from 2020, which is the first time that the President mooted the idea of a Most-Favored-Nation clause affecting the pharmaceutical industry. https://inflationguy.blog/2020/08/25/drug-prices-and-most-favored-nation-clauses-considerations/ The upshot is that even if the MFN policy takes place exactly as the President states, retail drug prices are unlikely to decrease anything like as much as he has said. In fact, there could even be some circumstances in which drug prices rise because companies stop selling in foreign countries at levels lower than in the US (because they face a more-elastic demand there) but which contribute to the total profit of the drug company. There may be others in which the drug company stops selling the drug at all in the US. Furthermore, drug prices overall have only risen 7% since pre-COVID, compared to 23% for core prices generally (the black line in the chart below is the overall CPI for Medicinal Drugs; the blue is the core CPI price level – both normalized to December 2019).
By the way, if I was concerned about importing APIs from China and wanted the US to start producing more of them, I don’t think I’d be trying to crush end-product prices and reduce the incentive to spin up production of the APIs. So there will be a lot of exceptions to the MFN policy, and you can tell from the performance of pharma companies yesterday after the news (big up with the market, not down!) that investors don’t expect any important impact on the bottom lines of pharmaceutical companies. I agree. I think Medicinal Drugs going forward will probably decline a bit for some celebrated cases, but not in a big way that pushes CPI lower significantly.
The big conclusion here is that inflation continues to run at about 3.5% or so (Median), and there is no sign of a significant further deceleration to come. As long-time readers know, this has been my theme for a couple of years, that we will end up in the ‘high 3s, low 4s’ on median inflation, because the overall backdrop of deglobalization and demographics argue for a higher floor. If the Fed keeps money growth very low, my opinion could change (and I’d already amend my target to ‘mid to high 3s’ as the mode), but I am not very optimistic on that.
However, I also don’t think there is anything about the inflation picture that argues the Fed has a lot of room to drop rates significantly. I said last month “The right answer to uncertainty from a policymaker perspective is to increase the hurdle for taking action. The right answer is to make no changes to policy. I am not confident that the Federal Reserve will correctly separate the ‘price of risk’ effect from the ‘economic growth’ effect. They are correct to note that tariffs by themselves are not inflationary in that they are one-off effects. If they believe that, and they think there’s a big recession coming, they’ll cut rates. That would be a mistake, especially given the uncertainty.” I still think that’s the case. At the moment, there is no reason to cut rates any further than the ‘let’s help Biden’ cuts did, except to appease the President and I see little urgency from this Fed to do that. I wouldn’t expect any big moves from the Committee, any time soon.
One final announcement. If you’re an investor in cryptocurrencies (in particular, stable coins) and have a Telegram account, consider joining the read-only USDi_Coin room https://t.me/USDi_Coin where the USDi Coin price is updated every four hours or so…and where these charts are also posted shortly after CPI just as I used to do on Twitter before they changed the API to make auto-tweeting charts very difficult.
Inflation After 100 Days
It is hard to believe that a third of the year is already past. Some people, of course, would say that it seems like a hundred years have passed in the first hundred days of Trump’s second term, but to me it seems like a blink.
Here’s a quick mark-to-market summary of where I think we stand with respect to inflation and the economy generally…after which I actually have another point for this column:
Uncertainty. That’s the watchword, of course. One place this shows up is in the huge spread between survey data and hard data. The survey data is tinted with fear of uncertainty, and is very negative (and likely influenced by the media deciding that Trump’s Administration signals the End of Days); the hard data is clearly softening but not dramatically so – and frankly, that was already under way in some ways since at least 2023 when the Unemployment Rate started heading slowly higher. In my view the softening of the hard data won’t ever get to be dramatic in this recession, and this will end up being more like a garden-variety recession we used to have pre-2000.
Inflation will be higher than it would otherwise be, because of tariffs, but lower than many people think because people greatly exaggerate the effect of tariffs. Tariffs only affect goods, and only significantly if they are goods facing inelastic demand. There will be some shortages in the near-term, and unlike during COVID when many of the shortages were caused by too much demand induced by money-drops to consumers, in this case it really will be supply constraints. Look out for things like ibuprofen, which is 90% sourced from China which makes it hard to completely switch supply to domestic suppliers. But these are short-run or in some case medium-run disruptions as supply chains shift. As domestic or lesser-tariffed countries replace the highly-tariffed suppliers, the supplies will respond and prices will come back down – not all the way to where they were, but it will feel like deflation in some cases because we mentally refer to the most-recent price, not to the year-ago price.
But either way, the tariffs are a jump-discontinuity, a one-time effect. The uncertainty, less so but that will fade (as an aside, and as I’ve noted previously, the high uncertainty had the effect in Q1 of causing money velocity to decline very slightly for the first time in a couple of years). By the end of the year, things will be much more settled and inflation will be stabilizing again…but the story continues to be that inflation will stabilize in the high 3s, low 4s, not at 2%. This probably means the Fed will not be easing much, although if there is a significant slowdown not caused from net trade – the Q1 drag was significantly from the surge in imports due to front-running tariffs – the Fed will ease even if inflation hasn’t come down. They’ll point to tariffs being transitory, although I sincerely doubt they will use that word! And they’ll be right, but they’ll also be wrong. Money supply growth is still too fast to accommodate 2% inflation especially in a deglobalizing world.
We’ll talk more about all of these things in columns here and in my podcasts over the next few months. But today I am still very preoccupied with getting USDi[1] launched, getting investors involved, talking to crypto ecosystem providers, etc. And I want to address one question I get routinely these days – not just about USDi, which exactly tracks CPI but adds nothing on top, but about the underlying investment strategy that I’ve been running/marketing for 3.5 years. The question is, “why should I buy something that returns CPI when inflation is at 3% and I can buy Tbills and earn 4.25%?” Here are two important pieces of the answer – and they’re just as important to investors who operate wholly in the traditional finance world as it is to people operating in the crypto world.
The first part of the answer is that while Tbills are above inflation now, that is not exactly guaranteed. In fact, for the last quarter-century it has been fairly unusual.
Sure, if you go back to the 1980s and early 1990s, when inflation was high and coming down and the Fed was following inflation down, you can find a lengthy period when Tbill rates were above inflation. Is the current period, with inflation where it is, comparable to the period when inflation was descending from double-digits and the FOMC was dominated by hawks? Do you think Trump will replace Chairman Powell and other Fed governors whose terms expire, with hawks? It doesn’t seem that way to me. I think it’s important to realize that is the bet you’re making, if you hold short cash instruments as an inflation hedge.
The second part of the answer is that holding a cash instrument does not protect you during an inflation spike because the Fed cannot respond fast enough, and a cash instrument in nominal space does not protect you from a dollar crisis. Almost nothing does, in fact, as stocks and bonds both do poorly in those cases as do ‘inflation hedge’ products based on equities or bonds. Here is a chart of the recent inflation spike. How well did your Tbills, or short-duration bonds (VTIP) or long-duration inflation bonds (TIP), keep up? Did they ever catch up?
To me, any allocation to low-risk securities that is meant to serve as a volatility buffer for a portfolio, but does not hold inflation beta, is completely missing the value of that beta in certain scenarios where very little else is helpful. When inflation spikes, stocks and bonds become correlated (down). You can (and should) add commodity allocations to your portfolio, but those consume part of your risk budget and push out the equities, hedge funds, private equity, and other higher risk asset classes. If you can get the inflation beta from a very low-risk part of your portfolio, you ought.
The foregoing is, transparently, partly self-serving. But the products I’ve been involved with developing have never been developed because they produce big fees or are easy to sell.[2] I’ve developed them because they’re useful to investors. And, parenthetically, I do think that the worker is worthy of his wages.
If you want to find out more about USDi, I urge you to visit the home page https://usdicoin.com, where you can see the current value of the coin increasing minute-by-minute with inflation. If you’re a denizen of the crypto world, then you might also be interested in joining the Telegram read-only group for the USDiCoin, available at https://t.me/USDi_Coin. That group is where we will make announcements about the coin, post the price of the coin periodically (at least daily; automation in process), post the monthly reports confirming the collateralization of the coin, announce new market-makers and markets…and also post some inflation-related charts, such as I used to do on Twitter on CPI morning, when Twitter allowed such automation. If you’re at all interested in inflation and/or the inflation-linked coin, hop on.
[1] If you don’t know what USDi is yet, read my prior article https://inflationguy.blog/2025/04/15/announcing-usdi-inflation-linked-cash/
[2] Understatement of the century.
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.”
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).
