Inflation fears are overblown

Stock market bears are fixated on the belief that inflation is not only "running hot" but also "accelerating." Nothing could be further from the truth. 

Some charts that help put things into perspective:

Chart #1

Chart #1 shows that existing home sales have fallen by 36% in the past year. This is extraordinary. Given the lags in reporting this data, the reality is likely worse. We are in the midst of dramatic weakness in the housing sector. 

Chart #2

Chart #2 shows the likely culprit: a once-in-a-lifetime surge in the cost of borrowing money to buy a house. 30-yr fixed rate mortgages are now back to 7%, which is more than double the level that prevailed just over a year ago. Combined with rising home prices, this has increased the cost of buying a house by at least one-third in a very short time span. It's likely that the market has not yet had time to fully adjust to this new reality. It can only mean further weakness in the housing market.

Chart #3

Chart #3 shows that applications for new mortgages have dropped an astonishing 58% in the past year. The Fed missed the signs of rising inflation (they should have been watching M2 growth years ago) and now they have slammed on the brakes and are talking tough. Sharply higher interest rates, in turn, have dramatically affected the public's ability and willingness to buy a home. There is no question that monetary policy has had a dramatic impact on the real economy and on prices. Conclusion: the Fed should stand pat and watch how things evolve from here. 

Chart #4

Chart #4 compares the level of 30-year fixed mortgage rates (white line) with the 10-yr Treasury yield (orange line), and the spread between the two (bottom half of the chart). This is what happens when bond yields surge unexpectedly: investors in bonds and mortgages have been burned (it's been the worse bond market in many lifetimes) and now they are twice shy. Demand for these securities has collapsed, pushing mortgage rates to an almost-unprecedented level above that of 10-yr Treasury yields. Normally this spread would be about 150-200 bps, but now it's over 300. The bond market has amplified the Fed's tightening efforts. It's VERY expensive to borrow at fixed rates these days.

Chart #5

Chart #5 shows that natural gas prices have truly collapsed, falling by way more than ever before in a short span of time. Traders say it's due to warm weather in the East. Regardless, this is an important source of energy for vast swaths of the economy, and it equates to a powerful deflationary force. And let's not forget that oil prices have plunged 35% from their highs last May. It's not just the weather; commodity prices are down across the board over the past 6-12 months. Monetary policy is undoubtedly one of the reasons. 

Chart #6

Chart #6 tells us that the bond market feels pretty good about the outlook for inflation. The spread between 5-yr Treasuries and 5-yr TIPS is now less than 2.5%, which means that the bond market expects the CPI to average less than 2.5% per year for the next 5 years. Higher interest rates have convinced bond traders that the Fed has done enough. Chairman Powell, are you listening?

Chart #7

Chart #7 compares the relative prices of services, non-durable goods, and durable goods. What an amazing divergence! Service prices are largely driven by wages, and durable goods prices have fallen thanks in large part to Chinese exports (which began to get underway in 1995). Durable and non-durable goods prices have been flat for the past 5-6 months, while service sector prices continue to rise. The Fed presumably worries that wages and low unemployment rates will continue to drive inflation higher. Do they really want to see bread lines showing up all over the country? Wages don't cause inflation: they are driven by productivity and the imbalances between the supply and demand for money. 

As for productivity: since 1995 service sector prices have increased 3 times more than durable goods prices! In rough terms, that means that one hour of the average worker's time today buys 3 times as much in the way of durable goods than it did in 1995. No wonder nearly everyone is able to afford to carry a super-computer, high-end camera, and internet connection in his or her pocket.

Chart #8

Chart #8 shows the year over year changes in the Personal Consumption Deflators (with the Core version being the Fed's favorite measure of inflation). Both rates came in a few tenths of a percent higher than the market expected. Does that sound like inflation accelerating? Or running hot? No. Inflation pressures peaked many months ago. Both of these measures are on track to show year over year gains that are much lower than their current level. It takes time for monetary policy–which is undoubtedly tight—to work its way through the economy. We just need to be patient.

Next Tuesday we'll have the all-important release of the January M2 money supply number. I expect it will show a continued decline, which will strongly reinforce the outlook for slowing inflation in the months to come. 

Inflation is still under control and the economic outlook remains healthy

Is inflation "running hot" because the January stats on the CPI and PPI were stronger than expected? No. Ups and downs in the monthly data are to be expected, so this is not necessarily something to worry about, especially since the macro picture hasn't changed for the worse at all.

Keep focused on the all-important monetary and macro variables: M2 and interest rates. The M2 measure of money supply is declining, and higher interest rates are increasing the demand for money; this is a one-two punch (an increased demand for a smaller supply of money) which is rapidly snuffing out inflation. Higher rates are having a big impact on the housing market, and the bond market continues to price in low inflation and a positive economic outlook. The dollar remains strong, gold is weaker on the margin, and commodity prices are soft. The result of all of this is that inflation pressures are declining on the margin.

One of the biggest factors behind the January CPI surprise was Owners' Equivalent Rent. Housing is a big component of CPI and it's been very strong of late, but this is almost certainly going to reverse later this year. Meanwhile, there is still no sign of the kind of economic or financial market stress that would trigger a recession.

And now some charts to round out the story:

Chart #1

Chart #1 compares the rate of increase in housing prices (blue line) with the rate of increase in the so-called "Owner's Equivalent Rent," (red line) which comprises more than one-third of the CPI. I've shifted the red line about 18 months to the left in order to show that changes in housing prices take about 18 months to show up in increases in OER. This means that the 2021 increase in housing prices is now boosting the CPI today, and this will likely be the case for at least the the next several months. But the chart also shows that there has been a significant slowdown in the rate of home price appreciation which began almost a year ago, so at some point—later this year—the OER component of the CPI will drop considerably. Worrying about the January "jump" in CPI inflation just doesn't make sense. You have to look at where the CPI is going to be going over the course of this year, and that is very likely to be in the direction of lower inflation.

Chart #2

Chart #2 shows the year over year and 6-mo. annualized rate of change in national housing prices. This adds force to the argument in Chart #1, because over the past 6 months, national home prices have declined. And the latest datapoint for this series (November '22) is based on the average of the previous three months, and prices have almost certainly softened in the most recent 3 months. That will pull the year over year change in housing prices well below zero, so OER will begin to subtract from CPI inflation within 3-6 months.

Chart #3

Chart #3 goes a long way to explaining why housing prices have dropped this past year. 30-yr mortgage rates have more than doubled. In fact, we've never seen mortgage rates increase so fast by so much. In turn, that has dramatically increased the cost of home ownership, on top of the increased level of prices. Housing has become unaffordable to millions of families in a relatively short period.

Chart #4

Chart #5

Chart #4 shows just how much the slowdown in housing has impacted residential construction. Housing starts have fallen 27% since their April '22 high, and homebuilders' sentiment as all but collapsed. As Chart #5 shows, building permits are down 30% since the end of '21, though they have been relatively flat for the past 3 months. It's a meaningful decline, but it's not likely to be a replay of the housing market collapse that led up to the 2008 financial crisis. There has been no overbuilding of homes, and Congress has not encouraged the banks to lend to marginal borrowers.

In short, there has been a massive adjustment in the housing market to higher interest rates, and it's going to put lots of downward pressure on the CPI starting later this year.

Chart #6

As the red line in Chart #6 shows, producer prices in January also surprised to the upside, but I strongly doubt this marks a change in the downward trend. The year over year measure continues to decline, and the 6-mo. annualized rate remains quite low, even though it ticked up in January.

Chart #7

Chart #8

Charts #7 and #8 show other measures of producer prices. They all tell the same story: on a year over year basis, core and total inflation continues to decline. And while the monthly measures ticked up in January, the 6-mo. change in prices remains at relatively low levels. The headlines should read: "Over the past six months, producer prices have been relatively stable." This all but ensures that the year over year measures of PPI and CPI inflation will continue to decline in the months to come.

Chart #9

Chart #9 compares the year over year growth rate of M2 (blue line) with the year over year growth in the consumer price index (red line), the latter being shifted one year to the left in order to show that it takes a year or so for changes in M2 to show up in changes in inflation. The decline in M2 this past year strongly suggests that CPI inflation will continue to fall over the course of this year. Steve Hanke and John Greenwood recently wrote about this in the WSJ, and they echo many of the things I have been saying in this blog. We have been on the same M2 page for a long time. (But I'm not quite as concerned about recession as they are.)

Chart #10

Chart #10 shows the Baltic Dry Index, which is a proxy for dry bulk shipping costs around the world. What it shows is that shipping bottlenecks have almost completely disappeared, and shipping costs have plunged. This augurs well for future world trade and prosperity, as well as lower input costs for many goods. The global economy is most definitely NOT "running hot."

Chart #11

Chart #11 is the Chicago Fed's Financial Conditions Index. Higher values reflect deteriorating conditions, while lower values represent improving conditions. There is no sign here of any impending recession. Ditto for Credit Default Swap spreads and for corporate credit spreads. Liquidity conditions remain healthy, and this argues strongly for healthy economic conditions in general for the foreseeable future.

The Fed's drive to push rates higher has made a significant difference in the inflation fundamentals, because they have dramatically altered the incentives to borrow, spend, and hold money. Higher rates have NOT adversely impacted the economy like they have in the past, moreover. Why not? Because the Fed has limited its tightening to interest rates while leaving an abundance of bank reserves in the system. It's not really the case that money is "tight" in the sense that it's hard to come by. The Fed has responded to the abundance of liquidity (and the 2020-2021 surge in the M2 money supply) by dramatically increasing (using the tool of higher interest rates) the world's incentives to hold on to money rather than to just spend it wantonly. And it's working.