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Corn Prices – Has the Correction Run its Course?

September 21, 2022 1 comment

Recently there has understandably been a lot of focus on the extremely high prices of agricultural products. The front Corn futures contract hit an all-time month-end high back in April, at over $8/bu (see chart, source Bloomberg). Over the last decade-plus, in fact, grain prices have been generally higher and more-volatile than in the 40 or so years prior to the GFC.

It is always good to remember, though, that because the overall value of the currency is in more or less perpetual decline, it is expected that the price of any good or service should be expected to rise over time. The more important question is, what has the real price of grains done over the decades? And here, the picture is starkly different and looks like the chart of many, many goods. It’s the way that the real price of consumer goods should look over time, given that the arrow of productivity points mostly in one direction. This one chart shows the price of corn, in 2022 dollars. Back in the 1970s, corn only cost $3/bu, but the dollar was worth more then. It would have taken more than $20 of today’s dollars to buy a bushel of corn in mid-1974.

The chart also has an orange line on it, which shows the US Cereal Crop Yield each year according to the World Bank.[1] I’ve inverted that series, so that when we are able to get more crops from each hectare, the line declines. It’s also on a logarithmic axis.

The point of this chart is merely to illustrate that real corn prices have declined over a long period of time because contrary to Mathus’s fears the production of cereal grains has been able to keep up and in fact exceed the increase in the demand for them over time. The chart is necessarily imprecise, since we’re not considering how the number of hectares producing corn changes each year, and we’re not looking at specific corn yields. Nevertheless, you will notice that many of the spikes in prices are associated with spikes (that is, dips, since it’s inverted) in crop yields. Which makes sense, of course.

What causes changes in crop yields? Different planting and harvesting techniques are obvious improvements that are pretty much one-way. Also, improved fertilizers and pest control, and better use of the proper mix of fertilizers. But then why do crop yields sometimes decrease, if all of these things tend to get better over time?

One obvious answer to that is the weather. Less obvious is that the use of fertilizers isn’t constant. When fertilizer prices are high, farmers try to use less and that reduces crop yields. Also – and this is directly relevant to today – when there is a shortage of fertilizer then less of it is used and the price of fertilizer goes up. With the conflict in Ukraine and the cutting off of natural gas supplies to Europe (natty is an important input into the manufacture of some fertilizers), we are in that sort of situation. If we overlay real corn prices with real fertilizer prices[2] you can tell that these are closely related series.

So in the long run, the general level of corn prices is driven by the purchasing power of the dollar (aka the overall price level) and the steady improvement in agricultural productivity. In the short run, corn prices are driven by fertilizer prices.

Fertilizer prices have come down somewhat. The continued embargo of natural gas into Europe has only a small effect on fertilizer supply, and Russia only directly provides about 10% of the global supply of fertilizers.[3] But the overall level of commodity inputs into the manufacture of various sorts of fertilizer obviously impacts the output price. I suspect it will be a while before fertilizer prices even in real terms get back to their pre-COVID levels. And the overall CPI is not about to decline any time soon. Does that mean that corn (and wheat, etc etc) prices can’t decline from here? Of course not – but my guess is that we’ve seen most of the good news on the agricultural commodity front for a while.


[1] https://data.worldbank.org/indicator/AG.YLD.CREL.KG?locations=US Annual data through 2020.

[2] US Cornbelt Urea Granular Spot Price, source Bloomberg. The 1:1 congruence of scales and amplitudes is mostly coincidental – one is cents per bushel and one is dollars per short ton.

[3] https://www.fas.usda.gov/data/impacts-and-repercussions-price-increases-global-fertilizer-market

What Happens Next?

March 29, 2022 3 comments

As far back as I can remember, I’ve been fascinated with the fetish that investors have about forecasts and predictions. When I was a strategist, clients wrangled me for a simple statement of where the market was going to go. I had my opinions, to be sure, but by the time I was a senior strategist I also knew that even good forecasters are wrong a lot. Forecasting, ironically, is not a job for people who care very much about being right. Because if they do care about being right, even good forecasters are depressed a lot.

So in my mind, a useful strategist was not one who gave all the right answers. Those don’t exist. A useful strategist was one who asked the right questions. Investing isn’t about being right; if it was, there would be no need to diversify. Just put everything in the one right investment. No, investing is about probabilities, and about maximizing the expected outcome even though that is almost never the best outcome given the particular path of events that actually transpires. Knowing the future is still the best way to make a million dollars.

A valuable strategist/forecaster, then, is not the one who can tell you what they think the actual future will be. The most valuable strategists have two strong skills. First, they excel at if-then statements. “If there is conflict in the Ukraine, then grain prices will soar.” Second, they are very good at estimating reasonable probabilities of different possibilities, so you can figure out the best average outcome of the probability-weighted if-then statements.

However, there aren’t a lot of great strategists, because those same characteristics are exactly what you need to be a good trader. I can’t remember if it was Richard Dennis or Paul Tudor Jones or some other legend who said it, but a good trader says “I don’t know what the market is going to do, but I know what I am going to do when the market does what it is going to do.”

As an investment manager/trader, that’s the way I approach investing. I don’t often engage in a post-mortem analysis about why I was wrong about how a particular chain of events played out, but I often post-mortem about whether the chain of events caused the market outcomes I expected, or not, and why.

All that being said, people keep asking me what I think happens next, so here is my guess at how the year will unfold. Feel free to disagree. I don’t really care if this is what happens, since my job is really to be prepared no matter what happens. But, you asked.

  • I suspect the conflict in Ukraine will continue for quite a while. I also think there’s a reasonable chance that other countries will take advantage of our distraction to be adventurous on other fronts. April is a key month, and I think Russia might be waiting for this other front to open up before pushing harder in Ukraine.
  • However, except inasmuch as the geopolitical uncertainty plays into the general deglobalization of trade, I don’t think about particular outcomes of Russian or Chinese adventurism. I don’t think the long-term inflation trajectory has a lot to do with who is invading who. In the short term it matters, but in the long run it means certain goods will have different relative prices compared to the market basket compared to what they have now – not that incremental inflation of those items, the rate of change of those relative prices, will continue. For example, cutting off the supply of Russian natural gas to Europe would permanently raise the relative price of nat gas in Europe, but after prices adjusted it wouldn’t permanently cause a higher level of inflation of natural gas.
  • March’s CPI print, released on April 12th, will probably be the high print for the cycle for headline inflation, at around 8.5%. Core inflation will also peak at the same time, around 6.50%. This is mainly due to tough comps, though. Monthly prints will still be running at a 4-5% rate, or higher, for at least the balance of the year, and we will end the year with core around 4.5%-5%.
  • The Fed is going to tighten again. I doubt they go 50bps at this next meeting unless the market is expressing desire for that outcome. The market sometimes fights the Fed, but the Fed these days doesn’t fight the market. The FOMC might even start reducing the mammoth balance sheet through partial runoff, but I suspect they will pocket-veto that and not do anything for a couple more months.
  • Interest rates are going to go up, further. Real interest rates are going to rise – actually, our model says that more of the rise in nominal interest rates so far should have been real rates, so TIPS are actually marginally expensive (which is very rare). Long-term inflation expectations are also going to continue to rise, until at least 3.5%…something in line with the reality of where equilibrium inflation really is now, with an option premium built in to boot.
  • Although the near-term inflation prints will come down, the increase in longer-term breakevens means that expectations of the forward price level will continue to rise. The chart below shows the level at which December 2027 CPI futures would be trading, based on the inflation curve, if some exchange actually had the courage to launch CPI futures. One year ago, the implied forward level of 310, compared to the November 2020 level of 266.229, implied that the market expected inflation from 2021-2027 to average 2.2%. That was in the thick of the “it’s transitory” baloney. Today, the theoretical futures suggest that inflation from 2021-2027 will average 3.6%, and that even ignoring the inflation we have seen so far, the price level will rise 3.25% per year above the current level over the next 5.75 years.
  • Stocks are going to decline. It is a myth, unsupported by data, that stocks do well in inflationary periods. At best, earnings of stocks may increase with inflation (and even exceed inflation in many cases since earnings are levered). But multiples always decline when real interest rates and inflation rise. Modigliani said it shouldn’t happen. But it does. And the Shiller P/E right now is around 40.
  • Then, the Fed is going to get nervous. Rising long-term inflation expectations will make the FOMC think that they should keep hiking rates, but the declining equity market will make them think that financial conditions must actually be tighter than they seem. And they’ll be afraid of causing real estate prices, which have risen spectacularly in the last couple of years, to decline as well. They will, moreover, be cognizant of the drag on growth caused by high food and energy prices, and in fact they will forecast slower growth (although it is unlikely that they will forecast the recession until it is over). And, since the Fed believes that inflation is caused by too much growth, rather than by too much money, the Committee will slow the rate hikes, pause, and possibly stop altogether. This is, of course, wrong but being wrong hasn’t stopped them so far.
  • Long rates will initially benefit from the notion that the Fed is abandoning its hawkish stance and because of ebbing growth, but then will continue higher as inflation expectations continue to rise. On the plus side, this will keep the yield curve from inverting for very long, ‘signaling a recession’, but a recession will come anyway.
  • Inflation by that point will only be down to 4-5%, but the Fed will regard what remains as ‘residual bottlenecks,’ since in their models a lack of growth puts downward pressure on inflation. They’ll stop shrinking the balance sheet, and may well start QE again if the decline in asset prices is steep enough or lasts long enough, or if real estate prices threaten to drop.

There you go – that’s my road map. I am not married to this view in any way, and am happy to discard it at any time. But I know what I am going to do when the market does what it is going to do. You should too!

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The Coming Peak in Inflation (and Why You Should Hold Off on the Party)

January 17, 2022 1 comment

Get ready for it: over the next month or two, the vast majority of stories on inflation – at least, in outlets that are friendly to bullish interests – will remark on the 40-year highs in inflation but append the following phrase:

“But economists expect inflation to moderate in the months ahead.”

This is meant to do two things, if you’re a PhD economist or a market observer with a BA in Art History (the difference in prognosticative ability between these two groups is remarkably slim). First, it is meant to be a soothing reminder that inflation is just a passing fad and nothing to worry about. Pay no attention to the man behind the curtain… Second, it is meant to demonstrate the powerful insights that the speaker commands. Look on my Works, ye Mighty, and despair!

But the contribution of this pronouncement is small. The reason that “inflation will moderate” in the months ahead is simply due to base effects. The table below shows the monthly CPI (seasonally adjusted, headline) prints from 2021, which will be “replaced” in the y/y figures over the next year. The numbers in red all represent inflation which, if annualized, would be 7.7% or higher.

Some of these high prints are driven by energy prices, which are historically mean-reverting, and some are also driven by spikes in “Covid categories” (most famously, used cars). And so most economists’ forecasts project a return to what the economist considers to be the “underlying run rate” of inflation. To illustrate this, look at the chart below. There are two lines. One, the blue line, represents what the y/y headline inflation rate would be each month if we simply naïvely replace every year-ago figure that is “dropping off” with 0.333%. Y/Y inflation is roughly flat for a couple of months since 0.33% is roughly what Jan and Feb 2021 saw; then it starts to fall sharply as we drop off 0.62%, 0.77%, 0.64%, and 0.90%. In fact, if we printed 0.333% on headline every month for the next year, Y/Y CPI would decline in every month except for two of the next 12.

The other line in the chart, in red, shows what is currently being priced in the market. You can see that not much more thought goes into market pricing than goes into economists’ forecasts!

Here’s the critical, salient point. Every forecast ends up showing this mean reversion because the usual way of doing projections naturally ignores unknown unknowns. From the top down, we have to choose something to replace last year’s number and the natural assumption is that the “top down” guess hasn’t moved terribly far from the prior guess (in the case of headline inflation, something like 2.0-2.5%; for 2022 maybe they’ll throw in 3.5% or 4% ebbing to 2%-2.5% in 2023). And from the bottom-up, we know what went up (for example, the spike in used car prices) and we also know that the rate of change of that item will eventually ebb. We’ve known that about used cars for a while. It hasn’t ebbed yet, confounding many, but it will. But do you know what else happened, the unknown unknown, that was not forecast back when everyone was thinking headline inflation would decline into the end of 2021? The acceleration in new car price inflation!

Indeed, one of the reasons that people thought that used car inflation would slow down and even that used car prices might decline is that used car prices were in some cases exceeding the prices of new cars, which is an obvious absurdity. But surprise! Due to “a chip shortage”, or the problem getting foam for seat cushions, or any one of a half-dozen other reasons – but perhaps also due to excessive government largesse – new car prices are now rising at 12% y/y. That was an unforecast “unknown unknown” early last year, and it is one reason that headline inflation ended the year at 7% rather than at 3%. Okay, so there was a “reason” for this surprise. But if you as an economist didn’t see that coming, what makes you think that you will see the next one…or that there won’t be a next one?

Rob Arnott used to make a similar point about corporate earnings. He pointed out that while the “extraordinary items” for any given company, which gets magically discounted when they report their “earnings before bad stuff,” may be a legitimate way to think about the profitability of that company going forward, for the stock market as a whole the amount of “extraordinary items” shouldn’t be discounted since someone is always having a surprise. It’s a surprise in the micro sense, but not in the macro sense. Surprises happen. Similarly, with inflation: we see economists decay away the surprises that have happened, while ignoring the possibility of other surprises.

If the distribution of those other surprises was random – some of them “inflationary” surprises and some of them “disinflationary” surprises, then this could make sense. The errors would be unbiased and so a forecast that ignores them would be less-volatile then reality, but not necessarily a bad “most-likely” guess. But in this case, the errors are likely to be on the high side because money growth remains around 12-13% per annum. Guessing that overall inflation is going to head back to 1.5%-2.5% over the next year or two is simply a bad guess. That it will decline from 7% is a high likelihood, but not exactly insightful.

There is a context in which this observation can be a useful contribution: by reminding the listener that when they see inflation decelerate in the months ahead, it doesn’t mean anything we don’t already know, a statement about the likelihood of declining year/year inflation can be helpful. This is the baseline forecast; only deviations from the expected path are worth reacting to.

And for my money, those deviations are more likely to be above the forecast curve than below it.

And Then There’s the Fed

By the way, if the most-recent inflation numbers were basically as-expected…and they were pretty much right on expectations…then why are Fed officials suddenly sounding more hawkish? An as-expected number shouldn’t change your views, unless your expectations were non-consensus. That seems unlikely when it comes to the flock of Econ PhDs who inhabit the Eccles Building.

I think the reason the Fed is sounding more hawkish isn’t because anything has changed recently – it hasn’t – but because they think we need to hear that hawkishness right now. It’s like a parent thinking that the kids “need” a stern talking-to. The kids, somehow, never think so.

As a Fed official, if you talk tough now you create several possible good outcomes. You might “re-anchor” inflation expectations by persuading investors and consumers that the Fed is determined to restrain inflation. It seems unlikely, given how often they talked in 2020 about having the tools to be able to prevent inflation – and then neither using the tools nor preventing inflation – that they’d get much mileage from that tack but it’s a free option. Or, you might be able to nudge market expectations in such a way that an actual hawkish turn won’t be as damaging as it historically has been. Or, to be cynical, one might think that a Fed speaker wants to get stern in front of the coming ‘base effects’ ebb, so that it looks to the gawkers in the cheap seats like they moved inflation by merely talking about it. And, in the worst case, you can back off the tough talk before you actually have to do anything.

I think there are a lot of reasons that the Fed is not going to be hawkish in any traditional sense; they’re not going to restrain money supply growth by shrinking the balance sheet and squeezing bank reserves (even if they wanted to, that margin is very far away), and they’re not going to raise interest rates in anything like the aggressiveness of a traditional tightening cycle – partly because they won’t be able to stomach the wealth effect of the market reaction to sharply higher discount rates, partly because sharply higher interest rates would cause big problems with the federal budget deficit going forward, and partly because they have convinced themselves that inflation is currently just ‘paying back’ a long period of being ‘too low’ (whatever that means). For now, expect them to aggressively and triumphantly forecast that “inflation will moderate in the months ahead.”

But you know the truth.

Categories: Uncategorized Tags: , ,

Summary of My Post-CPI Tweets (September 2021)

October 13, 2021 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • Here we are, #CPI Day again – where did that month go!? – And everyone is gathered around for the number. So many interested people! So many experts on inflation suddenly!
  • Last night, @TuckerCarlson led his show with a monologue re inflation. And he got it basically right, which is unusual for nonfinancial media. But the point is, “transitory” inflation is now important enough to get the lead on one of the biggest cable opinion shows in the world.
  • Which of course is why there are so many experts suddenly. Demand creates its own supply. But I am not complaining. There’s only one Inflation Guy and he has his own podcast https://inflationguy.podbean.com and app (in your app/play store)! [Editor’s Note: See the last bullet]
  • More importantly some regional Fed folks are starting to sound queasy. Atlanta Fed’s Bostic and St. Louis Fed President Bullard. The NY Times! The Wall Street Journal! The Poughkeepsie News-Gazette! Made up that last one but it’s everywhere.
  • Not the Chairman though, and not the Treasury Secretary, both of whom want the same thing: more money. Who was it? In the Volunteers with Tom Hanks I think: Mo money means mo power.
  • Meanwhile 1y and 3y expectations in the Consumer Expectations Survey are at all time highs since the inception of the survey in 2013. Which of course is why Carlson is leading with it. Consumers are noticing.
  • Are they only noticing because of used cars? Seems unlikely. They’re noticing broader pressures, which we are starting to see and still will be watching for in this report.
  • Speaking of used cars…while the rate of change might come down on some of these spikes, there’s no sign the LEVEL is retracing. See latest Black Book survey. “Holding steady” around 30% y/y. But that’s down from 50% in May.
  • Consumers are also noticing shortages, which is unmeasured inflation. If you put a price cap below equilibrium, you get shortages. And if you get shortages, you can presume the equilibrium price is higher. Repeat: Shortages are Unmeasured Inflation
  • Now, there’s good news. Delays at China ports are down. Although some of this is seasonal and some is due to the fact that…all the ships are sitting in OUR ports. But there is SOME good news anyway. Had to search for it.
  • Question going forward is how much of the pressure on suppliers gets passed through. It will be more (a) the longer it lasts, and (b) the more suppliers see others passing along costs. And profit season is about to start, where we will hear some of those answers.
  • In this CPI report today: the Street is expecting a very tame +0.2% on core, after a soft +0.1% last month. That seems very, very optimistic to me. If we get +0.27%, the y/y core rate will uptick to 4.1%.
  • And AFTER this, the comps are terribly easy so core inflation will be moving higher almost certainly for the next 5 months. The total for those 5 months in 2020 was +0.43% on core. The TOTAL.
  • So, core will be moving back towards 5%, even if the monthly figures settle in only at 0.2% per month. I’m not very optimistic that’s going to happen. But the Street is!!
  • We will be watching the usual ‘reopening’ items of course, but also watching RENTS and the breadth of this figure. And let’s not ignore food although not in the core – it’s one thing that consumers notice more than other things when it’s persistent.
  • I expect Rents to continue to move higher. So looking for that. And watching Median CPI, which set a new multi-year high month/month last month. It’s at 2.42% y/y and will be higher this month.
  • I’d also look at some of the “re-closing” categories that dragged down core CPI last month to reverse. Again, not a lot of sign that most prices are declining, even if rates of change are slowing.
  • Good luck out there. 5 minutes to the figure.

  • The economists nailed it! Well, mostly. Core was +0.24%, so at the upper end of the forecast range before rounding up. Y/Y went to 4.04%, also just barely not rounded up. But been a while since we were worried about rounding. Let’s look at the breakdown though.
  • Airfares plunged again, another -6.4% m/m. That’s going to change soon if vaccine mandates provoke more labor shortages there. But it does appear, from my own anecdotal observation, that airfares have been actually declining.
  • Lodging Away from Home -0.56% m/m. Used cars -0.7% m/m. Car and Truck rental -2.9% m/m. So, most of the “reopening” categories are still dragging this month, what I’d thought was a one-off. I didn’t think they’d top-ticked the prices before.
  • But New cars and trucks were +1.30% m/m after 1.22% the month before. As I’ve said before, the New/Used gap that closed when Used car prices spiked can open again in two ways. Used car prices can decline (no sign of that) or New car prices can rise.
  • Now, that was your good news for the day.
  • Primary Rents were +0.45% m/m, boosting y/y to 2.43%. OER was +0.43% m/m, boosting y/y to 2.90%. Whoopsie. Totally expected. And yet, kept seeing how the eviction moratorium wasn’t really holding down rents. Hmmm.
  • Medical Care, though, remains a soft spot for reasons that I just can’t fathom. Flat m/m. Pharmaceuticals rebounded to be +0.28% this month, but Doctors’ Services fell -0.30% and Hospital Services followed a strong month with a tepid +0.11%.
  • Apparel also plunged this month, -1.12% m/m. Small category, big move. Still 3.4% y/y, which is big for clothing, but it’s weird. With ports backed up, I’ve been seeing stock-outs in a lot of sizes of the stuff I buy. Shortages are unmeasured inflation. But still.
  • Quick look at 10y breakevens has them +3bps since before the number. The rents spike has people spooked. And it should. That’s the steadiest component. All of these large moves in little categories tend to mean-revert.
  • Core goods decelerates to +7.3% y/y (yayy!). But core services accelerates to 2.9% y/y (boooo!).
  • Core CPI ex-shelter dropped to 4.66% from 4.79%. So that’s the effect of all of these small categories. Meanwhile, rents boomed. And core-ex-rent at 4.66% isn’t exactly soothing.
  • Chart of core ex-shelter, and shelter. In the middle, you get core at 4%. If you want core to get back to 2%, you need core-ex to really plunge because shelter isn’t about to reverse lower.
  • Speaking of shelter, I hate to say I told you so but…and we have a long way to go.
  • Now let’s look at tuitions. Since we are in the Sept/Oct period, we’re going to find the new level of tuitions, which will be smoothed out over the next year with seasonals. This month, the NSA jumped 0.56%, and the y/y rose to 1.73% from 1.20%.
  • Tuitions aren’t going to jump a ton this year, but in 2022 I expect them to take a bump – partly to reclaim colleges’ purchasing power and partly because the product will be better next year.
  • Sorry, error. That was for the Education and Communication broad category. College Tuition and fees rose 0.96% m/m (NSA), and to 1.72% y/y from 0.83% y/y. Sorry.
  • Other goods. Appliances +1.55% m/m. Furniture and Bedding +2.35% m/m. Motor vehicle parts and equipment +0.85% m/m. Medical equipment and supplies +0.96% m/m. So doctors? Not so much. EKG machine? Syringe? Give me your credit card.
  • Breakevens dropping back. That’s profit-taking on the pop. They’re going to keep going up I think.
  • Biggest core m/m declines annualized: Public Transportation (-46%), Car/Truck Rental (-30%), Womens/Girls Apparel (-28%), Jewelry & Watches (-18%), Misc Personal Goods (-13%).
  • Biggest core annualized m/m increases: Motor Vehicle Insurance (+28%), New Vehicles (+17%), Household Furnishings/Ops (+13%), Motor Vehicle Parts/Equip (+11%), Infants’/Toddlers’ Apparel (+11%).
  • I said pay attention to food, which is what people notice. Overall Food & Beverages was +0.87% m/m. Some big movers: Meats Poultry Fish Eggs (+29% annualized), Other food @ home (15%), Cereals/baking products (13%).
  • Oh my. Median. My early estimate, which I hope is wrong, is +0.45% m/m. If I’m right that would be the highest in 30 years. On MEDIAN. Not meaningfully higher than that m/m since 1982.
  • If that’s right, the y/y would be 2.78%. Still short of the 2019 highs, but not for long.
  • That median calculation tells me I need to look at the diffusion and distribution charts. Which will take a couple of minutes to calculate. Please hold.
  • While we are waiting for the diffusion stuff, here are the four-pieces charts.
  • Piece 1: Food & Energy. The most volatile, but recently it’s just been up. And this is the part that people notice. Normally ignored because it mean-reverts. But it’s hard to get near-term bearish on energy or food, especially as the latter involves lots of pkging and transport.
  • Core goods. Coming off the boil because of Used Cars. Staying as high as it is because of New Cars and other durables. Sort of concerning it isn’t dropping faster.
  • Core services less rent of shelter. The one encouraging piece although it relies heavily on medical. Service providers not yet passing through wage increases so much. This is where the spiral would really happen, if it did.
  • Piece 4, and the news of the day. Rent of Shelter is now shooting higher, after being held down by the eviction moratorium and lack of mobility. This will set multi-decade highs over the next year, and as the slowest piece makes “transitory” much harder to believe.
  • The Enduring Investments Inflation Diffusion Index. Not that you need this chart to convince you, but price pressures are the broadest in about 15 years. And getting broader, fast.
  • So, here is the distribution of y/y price changes by base component weights. Note two things: (1) there is a long right tail, which is symptomatic of inflationary periods. Core above median. (2) The whole middle has shifted higher. This is of course largely rents.
  • So…we are getting higher inflation from the slow-moving pieces, and higher inflation from the fast-moving pieces. What’s not to like.
  • And finally, here is a chart of the weight of all components that have y/y inflation above the Fed’s target (which equates to about 2.25% on CPI, roughly). Highest in a long time. Only 1 in 5 purchase dollars is going to something inflating less than the Fed’s target.
  • So in sum…the overall 0.2% on core, which was nearly 0.3%, was the best news of the day. There is nothing in the details, distributions, or trends to make you think this is about to end.
  • Because of comps, we can be confident that y/y core and median inflation are going to accelerate for at least the next 5 months. And there’s nothing to convince me that the monthlies are going to stay nice and tame.
  • Transitory is dead. There is too much liquidity. The Fed now needs to choose whether to drain liquidity (not just taper), and live with much lower asset prices, or keep pumping asset prices “for the rich,” while we all ultimately lose in real purchasing power.
  • Powell is over a barrel, but to be fair he was also the cooper.
  • FWIW, I think the taper will happen. It will stop when one of two things happens: (1) Brainard replaces Powell or (2) Stock prices decline 15%. The Fed is fighting a war and they don’t even know it yet. They are working to keep the bread and circuses flowing.
  • That’s all for today. I will have the summary post up on http://mikeashton.wordpress.com  in an hour or less. Visit our website https://enduringinvestments.com ! Get the Inflation Guy app. Check out the podcast “Cents and Sensibility.” And stay safe out there.
  • Biden to meet with ports, labor on supply chain bottlenecks
  • I mean, this will definitely help, right? “Mister President, since you asked, we’ll clean it up.”

Biden to meet with ports, labor on supply chain bottlenecks

  • Just heard that the Inflation Guy app has been “temporarily” pulled from the Google Play store. Uh-huh. Totally normal. Waiting for the notice from Twitter that I’ve been kicked off for “spreading disinformation.”

One of the ways you can tell this is getting bad is that the people who told us this was all transitory, had nothing to do with money, and would be over soon are doing one or more things from this list:

  1. Pretending they never said it.
  2. Pretending they didn’t mean what they obviously meant.
  3. Getting angry because they were wrong and you were right.
  4. Accuse you of also being wrong because you didn’t specifically say Used Cars was going up.
  5. Trying to talk over, or squelch, the people who are bearing the bad news.

Last month, we had an 0.1% on core. But when you looked at the details, it wasn’t really soothing because it was being held down by the “COVID categories” which were falling again. You didn’t really have to squint, but you had to look below the headline. This month, we almost printed an 0.3% on core, and that was only because of those same categories (plus apparel), for the most part. You didn’t need to look hard to see the problem. Primary rents had their biggest m/m jump since 1999. OER, the biggest jump since the heart of the housing bubble in 2006. Those are big pieces, and we have a great deal of confidence that they are going to continue to rock-n-roll. After all, we have long said that rents were being restrained mainly by the eviction moratorium and would begin to normalize after the moratorium was lifted. Quod erat demonstrandum.

The trajectory of inflation is becoming clearer. The debate is no longer whether inflation is going up but how high it will get and when the peak will happen. That’s the right debate. The ancillary debate is whether the next ebb will be at 2% or something higher, like 3%. Some outliers still see the next ebb as serious deflation, but those are the same people who thought we wouldn’t see inflation when the Fed started printing money that the Treasury spent. [Note to the purists: yes, the Fed doesn’t “print” money, but it’s silly to argue that buying bonds for reserves isn’t equivalent ‘because it’s an asset swap.’ That’s just sophistry. It’s also an asset swap when I buy a refrigerator for cash, but circumstances have clearly changed for both buyer and seller when I do so. Anyway, go sell your crazy somewhere else. We’re all stocked up here.]

There is at least a sliver of good in this mess, and that’s that while investors in the main totally blew the chance to buy cheap inflation protection before this all happened (because they believed inflation was not a risk), and totally forgot that inflation affects not only asset prices but stock and bond correlations, they are re-learning these lessons from the 1970s and 1980s. And so investing hygiene will be better going forward. We have more tools to hedge inflation now than we did in the 1970s, and failing to use those tools in a healthy investment portfolio will no longer be acceptable.

And I know I don’t need to say it, but my company Enduring Investments is here to help those investors. Just like all of those other experts, except we’ve been here for longer.

Summary of My Post-CPI Tweets (August 2021)

September 14, 2021 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • Happy last- #CPI – day-of-summer! Is the transitory spike over?
  • Before we get started, a little housekeeping. Get the Inflation Guy app in your app store! And if you want to see some super-embarrassing photos of me, check out the Bloomberg Businessweek story just out today by @beth_stanton https://www.bloomberg.com/news/articles/2021-09-14/inflation-guy-michael-ashton-sees-more-on-the-way-as-investors-worry
  • The story is terrific. Beth is a fantastic journalist. But as for the pictures…I can just say, “I’m working on it.”
  • Anyway back to our story…This is the first time in months that the interbank CPI market has been at or slightly below the economist consensus estimate for headline inflation. (Pretty close though.) Previously, the interbank market was generally higher, and more accurate.
  • The last five actual prints on core CPI are +0.34%, +0.92%, +0.74%, +0.88%, and 0.33%. The consensus for today is a lowish 0.3% (something like 0.27%).
  • So economists – and the inflation market – are pricing in at least a LITTLE ‘transitory’ here with core inflation coming down from the peak…although I’ll note that 0.27% annualized is 3.3%. That’s still well above the Fed’s target. Not that they care very much.
  • That sort of month/month core CPI print today would see y/y drop to 4.2% from 4.3%, since last year we got +0.35% in August. Transitory! Yay! We win! Except that celebration will be short-lived.
  • The next 6 months of core range from +0.03% to 0.19% m/m. Very easy comps. So unless something weird happens, core inflation is going to be higher in 6 months than it is today.
  • I think there’s a little upside risk to the number today, partly because expectations are so tame. Used cars, which are past the y/y peak, still rose in price last month according to Black Book. So that would be a surprise.
  • However, that would distract from the more important issue this month and going forward: with the eviction moratorium lifted in many parts of the country, how fast do those units turn over at much higher rents?
  • I don’t really think that will be a big effect THIS month – too soon – but it will become increasingly important going forward. I’d even say it is THE story going forward in terms of how high core CPI will get in this ‘transitory’ bump.
  • OER and Primary Rents have started to see a little bump higher, although they were softer last month than in the prior month. I’m trying not to be obsessed with the wiggles. Anyway the lows are long past for rents.
  • Let’s be real: just as people waved away Used Cars as a “reopening category” or “idiosyncratic,” they’ll say the same with housing. “One time effect!” they’ll say.
  • But what will be harder to explain away will be inflation’s BREADTH. Our diffusion index is the highest in years, because it’s not JUST the reopening categories.
  • So be careful of all the “ex-cars” and “ex-reopening categories” metrics. They did that in the 1970s too. An increase in the number of anecdotes is what inflation IS, after all. Go listen to my “Diamond Water Paradox” podcast. https://InflationGuy.podbean.com/e/ep-2-diamondwater-paradox/
  • The PPI is telling us that the upstream pressures on materials, shipping containers, wages, etc are strong, and those pressures are broad. Yes, a lot of em are pressures on goods and not services. But it’s much more dangerous than hotel prices just catching up to the prior drop.
  • The next question people will ask: “Does this print mean the Fed taper is on?” And the answer is, I give a taper a 50-50 chance of starting and a 15% chance of completing. I don’t think the FOMC will be able to stomach the market correction.
  • So buy dips in breakevens if you see them, but I’d be more skeptical at selling nominals outright. Not sure the Fed will lock nominal rates as they did post-WWII, but they’re leaning against you.
  • And I said this last month and repeat it: Stocks probably go up either way on today’s number, because that’s what stocks do these days (until they don’t).
  • That’s all for now. My gut says a better chance for a high surprise than a low surprise today. And watch what happens to median CPI, later. Get the Inflation Guy app! Listen to the podcast! Follow the blog! https://mikeashton.wordpress.com Visit us at https://enduringinvestments.com  ! Good luck!

  • Team Transitory starts a comeback with a goal just before halftime!
  • 0.10% on core m/m, dropping the y/y to 4.0%. Not just a miss, but a big miss.
  • Used cars fell hard, -1.54% m/m. Last month I pointed out the m/m movement in the private surveys is only the same SIGN about half the time. But I fell for that this month as Black Book went up but CPI went down.
  • Lodging Away from Home -2.92% m/m. Gosh, wait a minute, look at this…
  • Are we going to have to call these the “re-closing” categories? Airfares -9.11%. Lodging AFH -2.92%. Used cars -1.54%. Car/Truck Rental -8.48%. Wow!
  • However, New Cars and Trucks – where you’re seeing the chip shortages and plant shutdowns for want of parts – was +1.22% m/m.
  • OER was +0.25% m/m, and Primary Rents put in a larger rise to +0.31% m/m. So let’s not get too excited about that miss right now…
  • Primary Rents, re-accelerating slowly. It will not be long until this is over 5%.
  • And OER. Again, these are the big pieces.
  • So core goods fell to +7.7% y/y from +8.5%, and core services fell to +2.7% from +2.9%.
  • Worth noting as the Biden Administration goes after pharmaceutical producers: CPI for Medicinal Drugs remains in deflation. Go get ’em, Joe.
  • Core CPI ex-shelter (which means less when Shelter isn’t leading the charge) fell to 4.79% y/y. In June this was 5.81%.
  • Apparel was +0.37% m/m, keeping y/y at 4.2%. Apparel is a small category, but we import almost all of it. So it isn’t surprising to see this rising for a change (but last month it had declined). At a 3% weight in the basket though, it doesn’t dominate anything.
  • Medical care outside of pharmaceuticals was flat in Doctor’s Services (+0.01% m/m), but up big in Hospital Services (+0.85% m/m). So the overall Medical Care subindex gained despite the weakness in drugs.
  • It’ll be interesting looking at the breadth this month. Seven of the eight major subindices rose, with only Transportation declining due to the Used Cars flop. Still shaking my head at the re-closing categories.
  • College Tuition and Fees +0.88% m/m. But that doesn’t annualize the way you think it does. It always jumps in August and September and then levels out for 10 months. The y/y is up to 0.83%. This is NOT quality adjusted, or it would be lots higher.
  • So the biggest decliners in non-food-and-energy: Car/Truck Rental (-65% annualized), Public Transportation (-49% annualized), Lodging Away from Home (-30%), Motor Vehicle Insurance (-29%), Used Cars and Trucks (-17%).
  • Biggest gainers: Jewelry and Watches (+23%), Motor Vehicle Parts and Equipment (+22%), Household Furnishings and Ops (+16%), New Vehicles (+16%), Men’s and Boys’ Apparel (+13%).
  • So…here’s the thing. My early guess at Median CPI is +0.33% m/m, which would be the highest since early 2007. So folks, this isn’t as tame a number as it looks like. Rents are rising, and inflation is broadening.
  • If you took out Used Cars, Lodging Away from Home, etc when they were spiking, then to be fair you should be taking them out now when they’re declining. Because that’s most of the story here.
  • Quick chart of y/y core goods and services inflation. Core Services has a much larger weight, and much of it is rents. Core goods off the boil but has a ways to decelerate yet.
  • Let’s do the 4-pieces chart and the diffusion index then wrap up.
  • Piece 1: Food & Energy. Steady upward pressure, but of course this tends to be mean-reverting.
  • Core goods – I already basically showed this chart. Used cars starting to decelerate and pull this down, but New cars accelerating. And broad pressure elsewhere. Watch this. If it goes only back to 3%, that’s a big deal. It’s been a deflationary force for many years.
  • Core Services less Rent of Shelter. Steady downward pressure in pharma, but upward in hospital services. Downward in public transportation. But still, not collapsed yet.
  • And piece 4, rent of shelter, the biggest and slowest and the story for the next year-plus. Going lots higher.
  • Actually while the diffusion index is calculating let me start the wrap-up. First: this number was truly weird in that reopening categories that had been leading the so-called ‘transitory’ spike were the ones that went down. I don’t know that anyone was looking for that.
  • But OUTSIDE of those “re-closing” categories, inflation was pretty solid. Rents and OER rose, although we haven’t yet seen much effect of the end of the eviction moratorium. We will. And there was pretty good breadth.
  • So what does this mean for the Fed? GREAT NEWS! A larger-than-expected decline in core CPI will give the doves what they need to demur on tapering. I think the odds of tapering just dropped. But they didn’t much want to taper anyway.
  • I don’t think this really changes the narrative – rents are going to drive core inflation higher, and the broadening inflation is going to help un-anchor inflation expectations – but it gives the most dovish Fed in 40 years cover.
  • 10-year breakevens at this hour are -2.5bps or so. They’ll be a little heavy as the carry traders lighten up, but this is a dip that is worth buying IMO. Of course, there aren’t many retail products where you can make that play.
  • Here’s the last chart. I pointed out the rents thing, which will be one big story going forward. The other is the broadening of inflation. The Enduring Investments Inflation Diffusion Index declined (vy slightly) this month, but it’s still at levels rarely seen in last 20 years.
  • That’s a wrap for today. I appreciate the follows, re-tweets, and counterpoints. If you’re interested in investing implications of all of this, hit our contact form at https://www.EnduringInvestments.com  Download the Inflation Guy app. Try out the podcast! Thanks for tuning in.

The upshot of today’s figures is simple: we expected the Used Cars, Hotels, and other “COVID categories” to flatten out after their big rebound. But no one that I know was looking for them to plunge again. That’s weird, but it makes analysis pretty simple. If you thought that it made sense to look through those one-off spikes to the underlying trends before (although the underlying trends weren’t all that encouraging, they were better than the spikes!) then you ought to probably look through the re-collapse. And outside of those “re-closing” categories, inflation is broadening and rents are accelerating, just like I’ve been expecting. So don’t get too excited that we’ve seen the peak in inflation just yet.

Remember the comparisons to last year get super easy here for the next six months. September 2020 was +0.19% on core inflation; then we have +0.07%, +0.17%, +0.04%, +0.03%, and +0.10%. And Lodging Away from Home won’t plunge every month – I’ll take the “over” on all six of these. And that means y/y core inflation is going to be accelerating from today’s 4.0%, for at least the next six months.

Moreover, median inflation is going go be rising towards those numbers too, as will trimmed-mean and the other better measures of the inflation distribution’s central tendency. There’s not much in this figure that is bona fide good news for the Fed. But I think they’ll take the win anyway, even if it’s on a bad call by the referee.

Summary of My Post-CPI Tweets (July 2021)

July 13, 2021 5 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments!

  • Another very special #CPI day! Welcome to my data walk-up.
  • Before we get started, let me tell you that I’ll be on @TDANetwork with @OJRenick this morning around 9:15ET. Accordingly, my post-CPI stuff might be slightly abbreviated. I’ll try to go quickly.
  • Setting the stage: we’re coming off of three consecutive upside surprises to core CPI. In each case, the interbank market trade was closer than the economists. Three months of 0.34%, 0.92%, and 0.74% m/m were impressive. Core CPI is at its highest since June 1992.
  • We were set to see the y/y figures rise on base effects anyway, but these were strong on a month/month basis – which have nothing to do with base effects.
  • It’s true the m/m figures were clearly flattered by the “COVID categories” like airfares (+7% last month) and used cars (+7.3% last month). But while the “transitory” crowd wants you to think that is the whole story, it’s not.
  • The truth is that the root cause here is phony demand caused by government spending financed by a loopy guy with a printing press. It is not “due to the reopening.”
  • I thought I made the point pretty well in “We Were Shocked – Shocked! – that Massive Stimulus Caused Inflation” https://inflationguy.blog/2021/06/23/we-were-shocked-shocked-that-massive-stimulus-caused-inflation/
  • In addition to the big outliers, there are a cluster of categories with y/y changes between 3% and 5%. Not all COVID categories! Our diffusion index is the highest since 2012.
  • So what is up for today. The ‘comp’ from last year is a more normal one, at +0.24%. The consensus economist forecast is +0.4% on core CPI, with the interbank market trading just a smidge higher than that. This sort of print would put y/y core CPI at (gulp) 4.0%.
  • Used cars still have some juice in them, based on Black Book and other numbers, so they’ll probably still be up in the ballpark of 3-4% m/m (huge error bars there). Still big, but getting to the end of the craziest m/m figures.
  • I want to keep an eye on new cars. That category is less volatile than used cars, but larger (~3.75% of CPI) and it looked last month like it was starting to accelerate.
  • There have been reports that some used car prices are above the prices of the same car, new. There are two ways that can change to something more normal. Used car prices can ebb, or new car prices can rise (or both, obviously). So keeping an eye on new cars.
  • Car rental rates have also been skyrocketing due to the shrunken fleets, and the surge in vacationers with stimmy money. Rental companies need more new cars.
  • But beyond the “COVID categories,” the key looking forward is (a) the breadth of the inflation increases, about which I’ve already commented, and (b) rents.
  • The eviction moratorium is still in place until the end of July, so the big catch-up that will happen when non-payers are turned out in favor of payers will not happen for at least a month or two.
  • But there is some evidence that the units that ARE turning over are at a high rent…so I suspect we will see more lift from rents this month, though the big months are ahead.
  • The timing of the end of the moratorium and the catch-up in rents is interesting, because the “hard” comps from 2020 are coming up. July ’20 was +0.54 core and August was +0.35%. So y/y might decline a bit over next few months (though this isn’t guaranteed with recent trends!)
  • Back at the beginning of the year, that was our expectation – a ‘fog of war’ from base effects causing a big jump then a big decline. However, the jump was bigger than expected and the decline may not be as impressive as we’d thought.
  • Rent catch-up might be worth 0.9% or so on core, so depending on how long the catch-up takes, the turn in the base effects might not be as impressive as we thought just a few months ago.
  • The Fed “cares” about such a move, especially if it’s broader… until stocks drop 5%. And then I suspect they’ll care more about keeping the wheels on the bus. So I’m not sure we’re about to see a sharp drop in QE very soon.
  • OK that’s all for the walk-up. Number is in 5 minutes. I think we might get a 4th upside surprise, but this is almost anticlimactic. The rest of 2021 is all about the rents.
    • duh, 2022.
  • And after August, the next 6 months of core CPI average just 0.1%. So folks, I don’t think we’ve seen the highs yet. If we average 0.3% per month on core, we could see 5% core CPI y/y by early 2021!

  • That’s a transitory bus that just hit us.
  • 0.88% m/m on core, pushing the y/y to 4.453%. So if it makes you feel better, both were rounded higher.
  • Well, CPI for Used Cars was +10.5% m/m, which is a lot more than I was looking for. That’s part of this.
  • COVID- categories: airfares +2.7% m/m. Lodging Away from Home (was flattish last month) +6.95% m/m. New Cars and Trucks +1.97%. Car and Truck Rental +5.18%.
  • Core Goods, thus, is at 8.7% y/y.
  • Of course, ex-everything-except- Medical Care, we are in deflation. Medical Care CPI was -0.10% this month.
  • Food Away from Home is up at a 4.23% y/y pace. But I am watching Food-at-Home, given the unrest we are starting to see around the world that smacks of the Arab Spring. Food-at-home was only +0.9% y/y.
  • Meat, poultry, fish, and eggs were +2.6% m/m, but most of the food-at-home category was reasonably well-behaved.
  • I haven’t mentioned rents yet because they were reasonably ham-on-rye. OER was +0.32% m/m, pushing the y/y to 2.34%; that’s a pretty normal monthly figure. Primary Rents, more directly affected by a spike in asking rents, was +0.23% m/m. So nothing there yet.
  • Core CPI ex-housing was 5.81% y/y, the highest since 1984. Of course it’s those COVID categories so this doesn’t tell us anything we didn’t already know. We’re going to want to look at the breadth.
  • Health Insurance was -1% m/m, and is now -6.9% y/y. Remember this was over 20% a while back and I THOUGHT that meant we’d eventually see pass-through to the other medical categories since Insurance is a residual. I’ve been wrong on that. No idea what is happening in med care.
  • So, we have a huge core number. What about median? In an inflationary cycle we’d expect core to be above median but a rise in median should still happen. Not worrisome yet…I am estimating +0.24% m/m for median this month.
  • at about 9:15ET, so as I said earlier this is a bit abbreviated. Apologies for that.
  • I have to go get ready to be on @TDANetwork
  • But here’s a quick summary: there’s nothing NOT scary about 0.9% on core. Except that there didn’t seem to be a lot of signs of further broadening of price pressures, and the pressure on rents hasn’t shown up yet. Indeed, Used Cars might have overextended & be due for a retrace.
  • We know what will lead the headlines! And four misses to the upside in a row runs the risk of un-anchoring expectations… but the next few months, post-eviction-moratorium, will be very important. Next two months will be tougher comps. But…0.9% would still beat them!

It was a quick one today. It is funny to think that just a few months ago, any 0.9% print on core CPI would have been interesting! Over the last quarter, prices have risen at a 10% annualized pace. Over Q2, core prices rose more (2.55%) than in the prior 18 months combined.

And yet, the 0.9% print was not too unusual. As noted, used car prices were up a lot more than I expected; basically, the entire spike in private surveys has now passed through to the CPI. Unless used car prices continue to rise at a similarly-blistering pace, that category probably shouldn’t add a lot to core CPI going forward.

New cars, on the other hand, are accelerating – the price of a substitute good normally does move in concert with the reference good – as the chart below shows. This is a potential source of surprises going forward. Or if not “surprises,” at least continuing momentum from the car crunch.

Other “COVID categories” were also bubbly. But that wasn’t surprising in itself. What I was on the lookout for was, as I said earlier, (a) a further broadening of price pressures, and/or (b) an early acceleration in rents even before the eviction moratorium expires, as various measures of asking rent suggest should be starting to happen. The chart below, of the Enduring Investments Inflation Diffusion Index, shows that the index was roughly unchanged this month near recent highs…so, no evidence yet of further broadening of inflation.

And, as noted above, Primary Rents and Owners’ Equivalent Rent were similar to the pre-COVID trend, but not yet reflecting the dynamics in the housing market. They almost always do, albeit with a lag. Our model below shows the effect of the moratorium as the difference between the current OER level and the model level, but note that the model also continues to rise for quite a while here. This is why it’s fairly easy to forecast that core inflation is going to stay elevated for a lot longer than the market is pricing. If the model is right, and rents rise at 4.75%, then if all core-ex-shelter components rise at only 2% the overall core index would still be at 3.1%. So when I predicted on TD Ameritrade Network this morning that core inflation for 2022 would average above 3% – a level it had not printed for even a single month in the last quarter-century until the last few months – I have some fair confidence in that. (Of course, the model could be completely wrong, or core-ex-shelter could be in outright deflation. But it’s also possible that core-ex-shelter could be rising at 3%).

This seems a good time to point out that 5-year breakevens are at 2.61% and 10-year breakevens are at 2.37%. There’s a lot of mean-reversion priced into those levels, and no long-tail-upsides.

This month, in short, we had COVID categories, broad inflation but no additional broadening, and no movement yet in rents. As far as 0.9s go, it was not too worrisome. On the other hand, if prices rise at a pace of 10% for very long then the Fed’s precious “anchored inflation expectations” are at serious risk. Ergo, I expect the Fed to start sounding more hawkish now. I also expect that they will drop the hawkish talk once stocks drop 5%. If stocks drop 10%, they’ll start actively talking about additional stimulus. This Fed is not of the talk-softly-but-carry-a-big-stick school. They’re of the talk-loudly-but-run-if-they-call-your-bluff type.

Why the M2 Slowdown Doesn’t Blunt My Inflation Concern

April 12, 2018 1 comment

We are now all good and focused on the fact that inflation is headed higher. As I’ve pointed out before, part of this is an illusion of motion caused by base effects: not just cell phones, but various other effects that caused measured inflation in the US to appear lower than the underlying trend because large moves in small components moved the average lower even while almost half of the consumption basket continues to inflate by around 3% (see chart, source BLS, Enduring Investments calculations).

But part of it is real – better central-tendency measures such as Median CPI are near post-crisis highs and will almost certainly reach new highs in the next few months. And as I have also pointed out recently, inflation is moving higher around the world. This should not be surprising – if central banks can create unlimited amounts of money and push securities prices arbitrarily higher without any adverse consequence, why would we ever want them to do anything else? But just as the surplus of sand relative to diamonds makes the former relatively less valuable, adding to the float of money should make money less valuable. There is a consequence to this alchemy, although we won’t know the exact toll until the system has gone back to its original state.

(I think this last point is underappreciated. You can’t measure an engine’s efficiency by just looking at the positive stroke. It’s what happens over a full cycle that tells you how efficient the engine is.)

I expect inflation to continue to rise. But because I want to be fair to those who disagree, let me address a potential fly in the inflationary ointment: the deceleration in the money supply over the last year or so (see chart, source Federal Reserve).

Part of my thesis for some time has been that when the Fed decided to raise interest rates without restricting reserves, they played a very dangerous game. That’s because raising interest rates causes money velocity to rise, which enhances inflation. Historically, when the Fed began tightening they restrained reserves, which caused interest rates to rise; the latter effect caused inflation to rise as velocity adjusted but over time the restraint of reserves would cause money supply growth (and then inflation) to fall, and the latter effect predominated in the medium-term. Ergo, decreasing the growth rate of reserves tended to cause inflation to decline – not because interest rates went up, which actually worked against the policy, but because the slow rate of growth of money eventually compounded into a larger effect.

And so my concern was that if the Fed moved rates higher but didn’t do it by restraining the growth rate of reserves, inflation might just get the bad half of the traditional policy result. The reason the Fed is targeting interest rates, rather than reserves, is that they have no power over reserves right now (or, at best, only a very coarse power). The Fed can only drain the inert excess reserves, which don’t affect money supply growth directly. The central bank is not operating on the margin and so has lost control of the margin.

But sometimes they get lucky, and they may just be getting lucky. Commercial bank credit growth (see chart, source Federal Reserve) has been declining for a while, pointing to the reason that money supply growth is slowing. It isn’t the supply of credit, which is unconstrained by reserves and (at least for now) unconstrained by balance sheet strength. It’s the demand for credit, evidently.

Now that I’ve properly laid out that M2 is slowing, and that declining M2 growth is typically associated with declining inflation (and I haven’t even yet pointed out that Japanese and EU M2 growth are both also at the lowest levels since 2014), let me say that this could be good news for inflation if it is sustained. But the problem is that since the slowing of M2 is not the result of a conscious policy, it’s hard to predict that money growth will stay slow.

The reason it needs to be sustained is that we care about percentage changes in the stock of money plus the percentage change in money velocity. For years, the latter term has been a negative number as money velocity declined with interest rates. But M2 velocity rose in the fourth quarter, and my back-of-the-envelope calculation suggests it probably rose in Q1 as well and will rise again in Q2 (we won’t know Q1’s velocity until the advance GDP figures are reported later this month). If interest rates normalize, then it implies a movement higher in velocity to ‘normal’ levels represents a rise of about 12-14% from here (see chart, source Bloomberg.[1])

If money velocity kicks in 12-14% over some period to the “MVºPQ” relationship, then you need to have a lot of growth, or a pretty sustained decline in money growth, to offset it. The following table is taken from the calculator on our website and you can play with your own assumptions. Here I have assumed the economy grows at 2.5% per year for the next four years (no mean feat at the end of a long expansion).

The way to read this chart is to say “what if velocity over the next four years returns to X. Then what money growth is associated with what level of inflation?” So, if you go down the “1.63” column, indicating that at the end of four years velocity has returned to the lower end of its long-term historical range, and read across the M2 growth rate row labeled “4%”, you come to “4.8%,” which means that if velocity rises to 1.63 over the next four years, and growth is reasonably strong, and money growth remains as slow as 4%, inflation will average 4.8% per year over those four years.

So, even if money growth stays at 4% for four years, it’s pretty easy to get inflation unless money velocity also stays low. And how likely is 4% money growth for four years? The chart below shows 4-year compounded M2 growth rates back thirty or so years. Four percent hasn’t happened in a very long time.

Okay, so what if velocity doesn’t bounce? If we enter another bad recession, then it’s conceivable that interest rates could go back down and keep M2 velocity near this level. This implies flooding a lot more liquidity into the economy, but let’s suppose that money growth is still only 4% because of tepid credit demand growth and velocity stays low because interest rates don’t return to normal. Then what happens? Well, in this scenario presumably we’re no longer looking at 2.5% annual growth. Here’s rolling-four-year GDP going back a ways (source: BEA).

Well, let’s say that it isn’t as bad as the Great Recession, and that real growth only slows a bit in fact. If we get GDP growth of 1.5% over four years, velocity stays at 1.43, and M2 grows only at 4%, then:

…you are still looking at 2.5% inflation in that case.

I’m going through these motions because it’s useful to understand how remarkable the period we’ve recently been through actually is in terms of the growth/inflation tradeoff, and how unlikely to be repeated. The only reason we have been able to have reasonable growth with low inflation in the context of money growth where it has been is because of the inexorable decline in money velocity which is very unlikely to be repeated. If velocity just stops going down, you might not have high inflation numbers but you’re unlikely to get very low inflation outcomes. And if velocity rises even a little bit, it’s very hard to come up with happy outcomes that don’t involve higher inflation.

I admit that I am somewhat surprised that money growth has slowed the way it has. It may be just a coin flip, or maybe credit demand is displaying some ‘money illusion’ and responding to higher nominal rates even though real rates have not changed much. But even then…in the last tightening cycle, the Fed hiked rates from 1% to 5.25% over two years in 2004-2006, and money growth still averaged 5% over the four years ended in 2006. While I’m surprised at the slowdown in money growth, it needs to stay very slow for quite a while in order to make a difference at this point. It’s not the way I’d choose to bet.


[1] N.b. Bloomberg’s calculation for M2 velocity does not quite match the calculation of the St. Louis Fed, which is presumably the correct one. They’re ‘close enough,’ however, for this purpose, and this most recent print is almost exactly the same.

RE-BLOG: Side Bet With Ben?

December 26, 2013 1 comment

Note: The following blog post originally appeared on June 14, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.

           

That said, there could be some signs that core CPI is flattening out. Of the eight ‘major-groups’, only Medical Care, Education & Communication, and Other saw their rates of rise accelerate (and those groups only total 18.9% of the consumption basket) while Food & Beverages, Housing, Apparel, Transportation, and Recreation (81.1%) all accelerated. However, the deceleration in Housing was entirely due to “Fuels and Utilities,” which is energy again. The Shelter subcategory accelerated a bit, and if you put that to the “accelerating” side of the ledger we end up with a 50-50 split. So perhaps this is encouraging?

The problem is that there is, as yet, no sign of deceleration in core prices overall, while money growth continues to grow apace. I spend a lot of time in this space writing about how important money growth is, and how growth doesn’t drive inflation. I recently found a simple and elegant illustration of the point, in a 1999 article from the Federal Reserve Board of Atlanta’s Economic Review entitled “Are Money Growth and Inflation Still Related?” Their conclusion is pretty straightforward:

“…substantial changes in inflation in a country are associated with changes in the growth of money relative to real income…the evidence in the charts is inconsistent with any suggestion that inflation is unrelated to the growth of money relative to real income. On the contrary, there appears to be substantial support for a positive, proportional relationship between the price level and money relative to income.”[1]

But the power of the argument was in the charts. Out of curiosity, I updated their chart of U.S. prices (the GDP deflator) versus M2 relative to income to include the last 14 years (see Chart, sources: for M2 Friedman & Schwartz, Rasche, and St. Louis Fed, and Measuring Worth for the GDP and price series). Note the chart is logarithmic on the y-axis, and the series are scaled in such a way that you can see how they parallel each other.

That’s a pretty impressive correlation over a long period of time starting from the year the Federal Reserve was founded. When the authors produced their version of this chart, they were addressing the question of why inflation had stayed above zero even though M2/GDP had flattened out, and they noted that after a brief transition of a couple of years the latter line had resumed growing at the same pace (because it’s a logarithmic chart, the slope tells you the percentage rate of change). Obviously, this is a question of why changes in velocity happen, since any difference in slopes implies that the assumption of unchanged velocity must not hold. We’ve talked about how leverage and velocity are related before, but an important point is that the wiggles in velocity only matter if the level of inflation is pretty low.

A related point I have made is that at low levels of inflation, it is hard to disentangle growth and money effects on inflation – an observation that Fama made about thirty years ago. But at high levels of inflation, there’s no confusion. Clearly, money is far and away the most important driver of inflation at the levels of inflation we actually care about (say, above 4%!). The article contained this chart, showing the same relationship for Brazil and Chile as in the chart updated above:

That was pretty instructive, but the authors also looked across countries to see whether 5-year changes in M2/GDP was correlated with 5-year changes in inflation (GDP deflator) for two windows. In the chart below, the cluster of points around a 45-degree line indicates that if X is the rate of increase in M2/GDP for a given 5-year period, then X is also the best guess of the rate of inflation over the same 5-year period. Moreover, the further out on the line you go, the better the fit is (they left off one point on each chart which was so far out it would have made the rest of the chart a smudge – but which in each case was right on the 45-degree line).

That’s pretty powerful evidence, apparently forgotten by the current Federal Reserve. But what does it mean for us? The chart below shows non-overlapping 5-year periods since 1951 in the U.S., ending with 2011. The arrow points to where we would be for the 5-year period ending 2012, assuming M2 continues to grow for the rest of this year at 9% and the economy is able to achieve a 2% growth rate for the year.

So the Fed, in short, has gotten very lucky to date that velocity really did respond as they expected – plunging in 2008-09. Had that not happened, then instead of prices rising about 10% over the last five years, they would have risen about 37%.

Are we willing to bet that this time is not only different, but permanently different, from all of the previous experience, across dozens of countries for decades, in all sorts of monetary regimes? Like it or not, that is the bet we currently have on. To be bullish on bonds over a medium-term horizon, to be bullish on equity valuations over a medium-term horizon, to be bearish on commodities over a medium-term horizon, you have to recognize that you are stacking your chips alongside Chairman Bernanke’s chips, and making a big side bet with long odds against you.

I do not expect core inflation to begin to fall any time soon. [Editor’s Note: While core inflation in fact began to decelerate in the months after this post, median inflation has basically been flat from 2.2% to just above 2.0% since then. The reason for the stark difference, I have noted in more-recent commentaries, involves large changes in some fairly small segments of CPI, most notably Medical Care, and so the median is a better measure of the central tendency of price changes. Or, put another way, a bet in June 2012 that core inflation was about to decline from 2.3% to 1.6% only won because Medical Care inflation unexpectedly plunged, while broader inflation did not. So, while I was wrong in suggesting that core inflation would not begin to fall any time soon, I wasn’t as wrong as it looks like if you focus only on core inflation!]


[1] The reference of “money relative to income” comes from manipulation of the monetary identity, MV≡PQ. If V is constant, then P≡M/Q, which is money relative to real output, and real output equals income.

Food Fight at the Fed!

September 23, 2013 2 comments

Now, now, children! Stop fighting! This is unbecoming!

It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.

Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.

updatedhousing

On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?

The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.

It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?

To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?

And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.

10ybei

I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.

One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.

Higher Rates, Higher Credit Growth: Sober Look

September 21, 2013 Leave a comment

I wrote recently about money velocity and reminded readers that theory says higher interest rates tend to increase money velocity because it decreases the demand for real cash balances. This was around the discussion of whether the enormous demand for Verizon bonds could be anecdotal evidence that velocity is increasing.

Yesterday the blog Sober Look – which is one of my favorites because it gives intelligent looks at many different markets – ran an article entitled “Could rising rates fuel credit growth in the US?” in which they in turn cite Deutsche Bank research. It’s a very quick article and worth a read, because it sheds some light on one of the mechanisms by which credit growth may increase with higher rates. Ordinarily, higher rates inhibit money growth at the same time that they increase velocity, partly because the yield curve flattens. But in this case, higher rates may increase both credit growth and money velocity – at least when rates initially rise – since the market is moving ahead of the Fed and steepening the yield curve in a selloff.

It’s just another puzzle piece to rotate in your mind, to try and see how it all fits together!

 

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