A close look at Inflation and interest rates

Headline inflation numbers are a bit higher than the Fed's target, but that's entirely due to the way shelter costs are estimated. On balance, it's clear that the Fed has brought inflation back down to acceptable levels. 

Relative to ex-shelter inflation, interest rates remain quite high, especially mortgage rates. The Fed has plenty of latitude to lower short-term interest rates, and I expect another cut in November.

Chart #1

Chart #1 looks at the headline measure of the CPI as well as the ex-energy version, both measured over a rolling 6-mo. annualized basis. Note how much less volatile inflation is when you subtract energy prices. These two measures currently are straddling the Fed's 2% target. Notably, the total (headline) CPI is up at only a 1.6% annualized rate in the past six months.

Chart #2

Chart #2 compares the total CPI to the CPI less shelter version, both on a 6-mo. annualized basis. Here we see that both measures currently are below the Fed's 2% target. Notably, the ex-shelter version is only up at a 0.1% annualized rate! If it weren't for the BLS's faulty measurement of shelter costs, which greatly overstates housing inflation, inflation would be essentially ZERO. 

As I've noted many times in the past year or so, shelter cost inflation has been high and declining slowly (more slowly than I expected). It should continue to decline over the next several months, and that will cause the current gap between total inflation and ex-shelter inflation to narrow.

Chart #3

Chart #3 compares the same two measures as Chart #2, but on a year over year basis. The ex-shelter version of the CPI has been less than 2% in 14 out of the past 17 months, and it currently stands at a mere 1.1%. 

Chart #4

Chart #4 compares the 5-yr Treasury yield to the year over year change in ex-energy inflation. I like to use this version of inflation, because as noted in #1 above, energy is far more volatile than any other component of the CPI. Here we see that interest rates tend to move with inflation, but with a noticeable lag. And with ex-shelter inflation now at 1.1% (note the blue asterisk at the bottom right-hand corner of the chart), there is plenty of room for Treasury yields to decline.

Chart #5

Chart #5 shows the level of real and nominal 5-yr Treasury yields, plus the difference between the two, which is the market's implied inflation forecast for the next 5 years. Inflation expectations currently are about 2.2%, which should please the Fed. Here again we see that there is plenty of room for interest rates to move lower.

As an aside, I note that swap and credit spreads are trading at relatively low levels, which is a sign of abundant liquidity conditions and a healthy outlook for corporate profits. Economic conditions in general are healthy, but I continue to worry about the housing and property markets, which are burdened by very high interest rates and high prices. 

Chart #6

Chart #7 shows the level of 30-yr fixed mortgage rates and the 10-yr Treasury yield, plus the spread between the two. Mortgage spreads currently are quite wide (about 225 bps), compared to where they trade in normal conditions (about 150 bps). This wider-than-normal spread is largely driven by investor's reluctance to buy mortgages when the risk of refinancings is high. People realize that interest rates are high relative to inflation, and they understand also that lower interest rates would spark a wave of refinancings of mortgages that have closed in the past two years. In other words, the perceived downside risk of mortgage bonds is uncomfortably high, and that is depressing the prices of mortgage bonds. If anything this means that while lower mortgage rates are likely in the offing, rates are likely to come down slowly. That will keep downward pressure on housing prices in the interim.  

This wasn't a monster employment number

This morning the market was apparently surprised by a stronger-than-expected jobs number. Private payrolls rose by 223K in September, vs. an expected gain of 125K. Some called it a "monster" number. From my perspective, however, nothing changed at all. Private sector jobs are growing by about 1.3 to 1.4% per year, as they have been for the past several months. This is moderate growth, probably enough to deliver overall economic growth of 2% per year or so. A nothing-burger.

Chart #1

Chart #1 shows the year over year change in private sector jobs, the only ones that really count. The big story, really, is the huge deceleration in growth over the past few years, followed by relatively moderate and steady growth in recent months. Even if we looked at jobs growth over a 6-month period, the story would be the same. Jobs numbers are very volatile on a monthly basis, so you have to look at growth over a multiple-month basis. And when you do that you see that nothing much has changed of late. 

There is nothing in today's report that should influence the Fed to change course. Inflation is yesterday's problem, and jobs growth is moderate. Lower interest rates are appropriate.

Looking pretty good: M2, GDP and corporate profits

I'm certainly not an apologist for the Biden administration, but as the charts below show, the economy on balance has done pretty well in the past several years. The monetary source of the Big Inflation of 2021-2022 has been largely extinguished, real economic growth has exceeded expectations, and corporate profits have been fairly spectacular. 

Chart #1

Recent revisions to the GDP statistics showed the economy posting better than 2.3% annual growth over the past several years (see Chart #1). Of course, this is still far less than it might have been had the economy tracked the 3.1% annual growth path that began in 1966 and continued through 2007. But, considering that many observers were predicting a recession in 2023, economic growth has been surprisingly strong. My own forecast of growth in recent years called for growth slightly in excess of 2% per year, and I am pleasantly surprised to have been too cautious, albeit much more optimistic than most. 

Chart #2

Chart #2 shows the level of the M2 money supply. The huge bulge in M2 tracks the massive government stimulus payments in 2020 and 2021 that were essentially financed by money printing. With a delay of about a year, some $6 trillion of monetary "stimulus" subsequently turned into raging inflation in 2021 and 2022. The Fed was unfortunately slow to react, but by late 2022 they had raised rates by enough to neutralize excess M2 and thus slow inflation. 

Chart #3

Chart #3 is key to understanding the interaction between excess money and inflation. A $6 trillion surge in deficit-financed government spending was not initially inflationary, because the demand for money (which is proxied by the ratio of M2 to nominal GDP in in the chart) surged. That was the logical result of handing tons of cash to a public that had little desire and even less ability to spend it during the lock-down phase of the Covid disaster. But life began to return to normal in early 2021, and the public started to spend the money (i.e., money demand fell). The problem, of course, is that extra spending collided with supply-chain shortages and rising prices were the result. Money demand has almost returned to its pre-Covid levels now, the economy has resumed a more normal growth path, and inflation has become a non-issue for at least the past year. 

Chart #4

Chart #4 compares the level of corporate profits (after-tax, and ex Fed profits) with nominal GDP. 

Chart #5

As Chart #5 shows, profits are at all-time record levels compared to the size of the economy, and they began their current surge (briefly interrupted by Covid) in 2019, following Trump's 2018 reduction in the tax rate on corporate profits from 28% to 21%. Since the end of 2018, corporate profits (after-tax and adjusted for continuing operations and ex-Fed profits) have risen 58%, while nominal GDP rose 39%. Despite the sizable cut in tax rates, corporate tax payments to Treasury rose from a low of $189 billion in the 12 months ending Jan. '19, to $516 billion in the 12 months ending August '24—a whopping increase of 173%! And, not surprisingly, the S&P 500 is up 130% since 2018. 

Art Laffer, take a bow!

While it's great to see evidence that what's good for corporations is also good for the economy, there's a cautionary message here. If, as they have repeatedly promised, a Harris-Walz administration allows the Trump tax cuts to reverse as scheduled at the end of next year, this could pose a significant threat to the economy and, by extension, the stock market. 

Please excuse the absence of posts this past month. I haven't had much to say, and I needed a break. Plus, we had a delightful trip to Greece.