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.