Inflation is not a virus, and it's not going up

Inflation is not like a virus that spreads through a population. A rising price in one part of the economy cannot "infect" a price in another part of the economy. A currency doesn't just "catch" inflation because oil prices go up or a drought causes wheat prices to rise. Inflation is the result of an imbalance between the supply of money and the demand to hold it. It's a monetary phenomenon, as Milton Friedman taught us. And it generally results in a rising price for most goods and services.

The reason inflation appeared to rise last month, as the August CPI report implied, is not because of a monetary imbalance. As the charts below will show, the bulk of the apparent rise in inflation can be traced back to the way the BLS calculates inflation in the housing sector. There's another factor at work as well: the BLS can and does make mistakes, and numbers are typically volatile from month to month. Seasonal adjustment factors can be off and in need of revision. Consumer preferences for many goods change as prices change, but the BLS is slow to pick that up. The change in one month's number does not reliably mark a change in trend.

Chart #1

The Producer Price Index for Finished Goods (Chart #1) is a great illustration of the rather explosive inflation episode which the economy experienced from early 2021 to mid-2022. Prices were rising slowly from 2015 through 2020, then suddenly rose by more about 27% from early 2021 to mid-2022, only to once again resume a slow rise from mid-2022 through today. The fuel for that price explosion was a $6 trillion increase in the M2 money supply, a subject I've covered extensively in prior posts. From mid-2022 to August 2025, prices have increased at an annualized rate of only 1.4% with little or no sign of any meaningful acceleration. The return to low and relatively stable inflation was preceded by a dramatic contraction in M2.

Chart #2

The Final Demand version of the PPI (Chart #2) shows the same pattern. Although it rose at an annualized rate of 2.2% over the past 3 years, it is up at only a 1% annualized rate in the past six months.

Chart #3

Oil prices (Chart #3) show a rather sharp increase from 2021 through mid-2022, but they haven't increased at all since pre-Covid times. Since mid-2022, oil prices have actually fallen by 40%! Non-energy commodity prices have fallen by almost 10% since March '22. If inflation is on the rise, someone forgot to tell the commodity markets.

Chart #4

Chart #4 shows that the BLS's calculation for housing inflation today (which they call Owner's Equivalent Rent, or OER) is closely related to the year over year change in national home prices from 18 months prior. Today, home prices nationwide are barely increasing and are very likely to decline. Yet the BLS calculates that housing-related costs rose 4% in the past year. 

Chart #5

Chart #5 looks more closely at the behavior of housing inflation according to the BLS. In the past month, BLS calculates that OER rose at a 4.7% annualized rate, and is up at a 3.9% annualized rate over the previous 3 months. At a time when national home prices are on the verge of falling (and rents are flat to down), the BLS figures that housing inflation is accelerating! Trump is right to want a change in BLS leadership.

Chart #6

Chart #6 shows the 6-mo. annualized change in the CPI versus the ex-shelter version of the CPI. Without OER inflation, the CPI has been increasing at about a 2% annual rate for the past 3 years, and the rate of change has actually fallen to a mere 1.7% over the past six months. This means that the uptick in CPI inflation in August was driven by a big increase in the OER component of the CPI, as shown in Chart #5. 

Chart #7

Chart #7 shows the ratio of M2 to nominal GDP. I think that's a good proxy for money demand. Thanks to a big slowdown in M2 growth over the past three years, the amount of readily spendable money in the economy (M2) is almost back to pre-Covid levels. Excess money has been absorbed, and money demand is stabilizing. Thus, there is little or no reason to worry that inflation is coming back to haunt us.

California's Bullet Train Boondoggle

California voters approved the now-infamous high-speed-rail project in 2008; it was projected to cost some $33 billion and was to encompass some 800 miles, connecting Los Angeles to San Francisco, and the Central Valley to coastal cities, with an expected completion date of 2020. As I recall, the feasibility study for this project assumed that revenues from the LA-SF segment alone would exceed revenues from all other Amtrak lines in the country. After 17 years and over $15 billion in spending, not a single mile of track has been laid. Projected costs have tripled, and the scope of what is left of the project will deliver a 119-mile segment in the Central Valley, with no connection of SF or So. California. 

It is a manifest failure, and a monument to the fantasy that modern government can successfully and efficiently undertake complex projects. In just two decades, and for a tiny fraction of the cost of California's bullet-train boondoggle, Elon Musk's SpaceX has proved that point, going from zero to wildly successful and profitable, leapfrogging all other nation-sponsored space undertakings in the process. 

My good friend, talented artist, and fellow free-market advocate Nuni Cademartori has penned the cartoon which follows. May this boondoggle never be repeated, and may it swiftly be put out of its misery!

For more of Nuni's editorial artwork, check out my posts using this link. 

P.S. And may Gavin Newsom NEVER become president of the U.S.!

The appeal of small-cap stocks

Since March 2021, on a total return basis, small cap stocks have underperformed large cap stocks by almost 60%, according to Bloomberg. While surging prices for tech stocks (e.g., the Fab 7) go a long way to explaining why this has happened, it's also likely that tight monetary policy in recent years has also boosted large cap stocks at the expense of small caps. This case was bolstered by today's price action which followed Chairman Powell's speech in Jackson Hole, in which he indicated the Fed is getting ready to resume the easing of monetary policy that started two years ago but which has stalled since then.

Today was a good day for all stocks, but small cap stocks advanced 2.3% more than large cap stocks. So far this month, the total return on small cap stocks has exceeded the return on the S&P 500 by 4.7%. The following charts are telling us that this dynamic could have a lot more room to run.   

Chart #1

Chart #1 compares the level of the S&P 500, the most popular and well-regarded index of large cap stock prices, with the Russell 2000, the equivalent index for small-cap stocks. Over time, the chart shows that these two indices have experienced gains of similar magnitude, but there are times when they diverge. The two y-axis values are based on the fact that the S&P 500 index value tends to be about double that of the Russell 2000 index; or conversely, the Russell value tends to be about half that of the S&P 500. 

Background info: The Russell 2000 index contains the smallest 2000 stocks of the Russell 3000 index, and has a current market cap of about $3.1 trillion. The S&P 500 index, in contrast, has a market cap of about $55 trillion, and is composed of what could arguably be termed the 500 largest and most successful companies in the U.S. It's hard to imagine two indices with greater differences: big and successful vs. very small and obscure—David vs Goliath. Yet there are times when small caps outperform large caps, and we could be at the beginning of one of those times.

Chart #2

Chart #2 shows the ratio of the Russell 2000 index to the S&P 500 index. Small cap stocks have underperformed large caps by roughly 40% over the past 12 years, with the ratio declining from 0.64 to 0.36.  Over the period shown, the ratio has averaged 0.5, and it appears to be mean-reverting. Should the ratio revert to 0.5, that would imply a small-cap outperformance of roughly 35%.

Chart #3

Chart #3 compares the ratio of the small cap/S&P 500 indices to the level of the yield on 5-yr TIPS, which in turn is a decent proxy for how tight Fed monetary policy is (it's inverted to show that a rising red line equates to easier monetary policy, and a falling red line equates to tighter monetary policy). With the exception of a few periods, these two lines tend to track each other, thus reinforcing the thesis that monetary policy has an important influence on the relative behavior of small- and large-cap stocks. 

It is commonly thought that easy money is good for small cap stocks because small companies are generally more leveraged and thus more sensitive to changes in interest rates, whereas large companies are less leveraged and thus better able to weather adverse conditions, among other things.

What stands out of late is the divergence of the two lines which began about two years ago; monetary policy has been slowly easing (as seen in the rising red line) but the small cap ratio has been declining. Today's price action—in which small caps outperformed large caps by 2.3%—marks what could be an important turning point in favor of small caps—thus reestablishing historic patterns. Note that a similar (but opposite) divergence happened in the 2005-2008 period.