Tuesday, September 14, 2021

Money and inflation update

With today's release of the August CPI, it looks on the surface as if inflation is moderating, much as the Fed has been hoping. Looking deeper, though, I think it still pays to be skeptical—especially since the belief that this inflation flareup is merely transitory has been fully embraced by the bond market. Witness breakeven inflation rates of 2.3% on 5-yr TIPS. 

Chart #1

At the risk of making a fool of myself, I am going to assert that Chart #1 is what really makes this time different. Never before in the monetary history of the US has there been such a huge increase in the M2 money supply. The increased M2 growth we saw in the wake of the Fed's QE1 and QE2 casings were barely perceptible, as the chart demonstrates.

Now, large and rapid growth in the money supply isn't necessarily inflationary, providing it occurs at a time when the demand for money is surging. I think that was the case a year ago, given the Covid shutdowns that virtually paralyzed economic activity and the massive increase in spending as governments worldwide attempted to keep tens of millions of displaced workers afloat. But this year, things have improved dramatically. GDP has recovered all its lost ground and then some. Corporate profits are at a new high. Nobody today wants to have as much money on his balance sheet as he had last year at this time. 

Chart #2

Chart #2 shows how the mini-surge in inflation in the sunup to the Great Recession was later reversed. That's a picture of transitory inflation, I suppose, but don't forget Chart #1. The Fed never allowed the money supply to explode back then, and they kept interest rates much higher then they are now. The Fed was tight, and that's one thing that aggravated the crisis of 2008. So it's not surprising that inflation proved transitory.

But today is different. As Chart #2 shows, the Ex-energy version of the CPI has moved well above its long-term 2% trend. For the current inflation episode to prove transitory, the blue line is going to have rise at a much slower pace in the months ahead. And the M2 money supply is going to have to do the same. So far we see no evidence of either.

Chart #3

Chart #3 shows the 6-mo. annualized growth of the ex-energy and headline versions of the CPI. This measure is much more representative, in my view, of what is happening to inflation right now. A year over year version (which shows a distinctive slowdown) is muddied by the economic chaos that occurred in the summer of last year. Better to use data from the current year. By this measure, there has been no meaningful slowdown in inflation.

Chart #4

Today also saw the release of the Small Business Optimism survey. As Chart #4 shows, small businesses reported an explosion of price increases of a magnitude not seen since the inflationary 1970s. Prices for a whole lot of things are going up. This is big. 

Chart #5

As Chart #5 shows, housing prices nationwide are up by almost 20% in the past year (blue line). The red line represents the growth rate of the CPI component called "Owner's Equivalent Rent." I have shifted the red line to the left by 18 months, in an attempt to show that big increases in housing prices are followed, about 18 months later, by big increases in the OER component of the CPI (which represents almost 40% of the CPI, by the way). According to this chart, we have only seen the first glimmerings of a pickup in OER (and the CPI as well, by inference). Robust growth in housing prices this past year already strongly suggests we'll see a significant pickup in the CPI over the next 6-9 months. 

Chart #6

Meanwhile, the real yield on Treasury notes and bonds has become deeply negative, thanks to extremely low yields and a surge in inflation, as we see in Chart #6.. This represents a stiff penalty on anyone seeking a safe haven. This penalty is discouraging people from owning safe assets. It encourages people to spend some of the extra cash they have accumulated in the Covid era. And that is what is fueling price rises everywhere. This won't stop until real yields become much more attractive. And for that to happen we need to see the Fed raise rates and we need to see inflation come down. Unfortunately, neither of those conditions are likely to occur in the next year.

Chart #7

At the suggestion of a reader, I've updated Chart #7, a chart I have been featuring for many years now. My reading of this chart is that the market is still a bit nervous about the economy going forward, because the Vix at today's level of 18-20 is still somewhat elevated. But fears have been slowly subsiding, and so money has been finding its way into equity prices, among other things. Which is logical, since equities represent ownership of tangible and productive assets, and thus are a good hedge against inflation. And anyway, corporate profits are on the moon, as I pointed out last month. Housing and the stock market are the big beneficiaries of today's money abundance. 


Benjamin Cole said...

First, there is no chance that Scott Grannis can "make a fool of himself."

Years (decades?) of superb blogging and insights cannot be undone by one or two missed calls, which anybody who is brave enough to forecast will make. And I am not saying any missed calls have been made. The jury is still out on inflation.

I will now engage in rank cherry-picking.

The Cleveland Fed produces something called a "median CPI." It is up 2.4% in August, year-over-year.


Due to my job, I spend a lot of time looking at economies in Far East-SE Asia, although superficially in some regards. Still, no inflation to speak of. Places like Indonesia are having their central banks buy Treasuries directly from the national government. In general, these nations are doing what the US is doing, that is deficit spending and monetary stimulus.

Well, we will see what we will see.

griot1234 said...

W Polsce podobnie tylko robia to za posrednictwem Państwowych banków aby obejść prawo. Pozdrawiam

steve said...

IF you're right-and I have no reason to believe otherwise, then one must wonder why the ten year stubbornly stays so low in yield. I posit that supply and demand forces are overwhelming common sense inflation' forces and the days of rates reacting to inflation like they are "supposed" to are over. If that is correct then positioning for inflation is largely moot.

wkevinw said...

The money printing experiment has morphed in ways few predicted. I am wondering if we are seeing the "bad money driving out the good" being played out. This was posited to explain precious metal/currency backing, but I think now comes into play with the money printing- which creates paper asset bubbles.

Example- money-losing enterprises, and even some that "make money", like Amazon, have a lot of money that comes from asset appreciation (read stock market bubble). That money sometimes drives cpi prices up, and sometimes not, depending on where it resides in the system- reserves, balance sheets, or checking accounts.

There are two ways to get money now- the old way of working for it, and the new way of getting it handed to you by a central bank.

We get the modern feudalism of today and economic variables that disconnect from each other, at least until they don't.

In 2008 we had a crazy set of variables, and that corrected. It can happen again.

Chris said...

What is your estimate of full-year 2021 CPI inflation? And when will we learn of the govt's calculation of this? Thanks.

Scott Grannis said...

Chris, re "what is your estimate of 2021 CPI inflation?" I'm going to guess 7%, and I'll add that if I'm wrong it will be even higher. We'll find out if I'm right by the middle of January next year, when the December CPI is released.

Grechster said...

I'm open-minded to your inflation thesis, but skeptical.

The bond market is saying there's nothing to see here. Ditto gold.

Breakevens on fives and tens are super stable.

I keep coming back to MV=PY.

Very little in the past 13 years has changed the basic construct: Materially higher M, materially lower V. This results in low-but-positive P and low-but-positive Y. Even COVID could only move the timing around, but the basics above are holding.

I continue to watch with interest too, but I'm a doubting Thomas on (big-time) inflation. The next step is to see what happens in the labor market now that the government has recently stopped paying people to not work. As always, we'll see.

Carl said...

What is surprising in a way is the relative absence of incredible inflation after such an unprecedented, coordinated (and wildly excessive) monetary/fiscal "stimulus" package. The consumer and corporate income support (stimulating a simultaneous deeply negative trade balance so the effect has been global) rapidly became a debt-fueled excess cash on the private side and people are rejoicing as result since real rates are negative?
Who knows, maybe 'we' will muddle through and higher and sustained inflation is possible but higher concerns for wage pressures and inflation at the small company level are typically a late stage phenomenon in the cycle. See following link. Nobody seems to remember these days but in 2007, a widespread concern was rising inflation..
Anybody with horse racing experience here? After a certain point, horses tend to run gradually slower with age and there are reasonable ways to help delay the 'depreciation' and there are even other ways (substance enhancing) to obtain surprising results for maybe one more additional year. What is realized though is that the stimulus-output relationship rapidly gets massively unfavorable and you eventually get a rapidly deflating value horse. Of course, the alternative is to 'bet' on another horse.

K T Cat said...

I'm a rank amateur in reading these things, but in my life, it sure looks like inflation, when everything is considered, is way higher than what's being reported. My real estate and stock investments are en fuego right now. We love to cook and I pay attention to food prices. Those are a lot higher, but not like our investments. Gas is higher, too.

What occurs to me is that there is only so much driving and consuming I can do and the same goes for you. All that excess money has to go somewhere, so after a little extra consumption, the rest is going into stocks and real estate. Inflation is there, right in front of us, but it's in the SP500 and real estate prices.

wkevinw said...

K.T. Cat---"Inflation is there, right in front of us, but it's in the SP500 and real estate prices."

I have never liked the "asset(S&P500) inflation" argument. It's asset appreciation and different from normal "inflation". It is certainly not consumer or producer inflation. It's a type of "savings".

Real estate- the CPI contains owners equivalent rent as the largest fraction of any input. I believe data are acquired by survey (not market study)- as in what owners think their house would rent for. It was proven to be in large deviation from other measures such as the Case-Shiller index- which I believe was a root cause of the debacle in 2008 (that the incompetents at the Fed couldn't figure out). Between ~2000-2007 owners equivalent rent was ~+30%, Case-Shiller was ~+85%. That's too big of an error.

Scott Grannis said...

Re my 7% guess for the CPI this year: In reviewing my numbers, I now guess it's going to be a little over 6%. That assumes that monthly inflation rate for the rest of the year (0.45% per month) is moderately lower than what we have seen year to date (0.54%). I still think that if I'm wrong, inflation will be higher than 6%.

Carl said...

"We love to cook and I pay attention to food prices."
Maybe you will like this short discussion on the hot potato effect then.
It's a helpful concept that is related to money velocity and can help differentiate consumer inflation and asset inflation.
Looking at monetary velocity, it's become clear at least so far that 'excess money' associated with increased money supply has been associated with decreased velocity resulting in very low inflation.
Looking at asset prices, the 'excess money' associated with increased money supply has been, as you suggest, very effective, at least so far.
It's also interesting to note that wage inflation is lagging consumer inflation which should not be the case if this period had reached a non-transitory phase. There is a lot of noise about the artificially inflated retail sales' trends since early 2020 but real retail sales growth looks very weak (from a consumer point of view, a consumer who doesn't have much in term of assets; ie the majority of Americans).
Anyways, i'm quite stupid overall but i think many people don't quite get this all-this-money-on-the-sidelines thing.
Take the following and see the deposits graph:
The author (who is intelligent and articulate and who gets some of the derivative conclusions) doesn't seem to realize that cash appeared in accounts mostly due to a simple huge asset swap (short term government debt exchanged for newly printed cash) where the previously held bills did not show up as a "deposit" and where the exchanged cash does. Also most of the residual deposits growth came as a result of the effective direct financing of the government through commercial banks and we know most of this money is not going to productive use but for transfers and 'welfare'.
"Excess" money appearing this way will only disappear from the sidelines (bank accounts) if people start to hide it in mattresses or if the underlying debt (circulating in the financial system also) is retired. Otherwise this hot potato money will simply leave one account to go to another.
i submit a better way to look at the growing money supply is through a graph i built using FRED data. i hope it can appear with the following link.
i submit that the line showing deposits growth minus QE and commercial bank financing to the government reveals, in a more effective way, the 'real' and productive amount of money that has been created.

minnesota nice said...

With so much global debt at negative interest rates, I don't think we can completely rely on the bond market. It's going to take a lot of inflation to push the 10y over 2%. Heck, it'll take a lot of inflation just to get to 2%.

Benjamin Cole said...

Milton Friedman may have been right about money and inflation.

But is seems to me inflation as measured is another topic.

Suppose people (due to C19) switch from spending in bars, restaurants, salons and public transit to buying goods? The prices in service establishments or public transit might trim down, but probably not. Many will just go out of business. But prices of goods bought might rise, due to scarcities. See autos.

Housing is another doozy. Restrict supply, and prices/rents rise. The monetary authorities might be sober, but ever tighter housing markets will result in higher prices, as measured.

Here is another example: Say you live in a crime-free world. Then, say, there are crime waves. For businesses to stay open, they must hire security guards, cameras etc. Inevitably, this will increase minimum costs of staying in business, and thus higher prices, and thus inflation as measured.

Some people say if the Fed just held money supply steady enough, lower prices in some segments would offset the higher prices in other segments. That assumes some segments are able to lower prices, rather than just go out of business. But competitive markets many businesses operate on thin margins.

The best way to fight inflation is open up markets to fresh supply, especially housing. Throwing criminals into jail would probably help too. And declare victory on C19 and move on.

Scott Grannis said...

When bonds have negative real interest rates that indicates two things: 1) those who own the bonds are losing purchasing power to those who issued the bonds, and 2) the demand for the relative safety of bonds is intense (because their price has been pushed up so high). The net result is that the risk averse among us are slowly but surely losing money while the risk-prone are earning money. It's a massive wealth transfer. This is not sustainable for very long.

Carl said...

^If interested, here's a nice exposé on negative interest rates:
Excerpt (page 14 in the pdf document):
"This is not a fleeting phenomenon, nor is it limited to a few exceptional
countries. This phenomenon has persisted for close to half a decade in many
regions, and signs are that it could persist for quite a while longer. The negative
yield phenomenon is present in most northern European countries (Sweden,
Switzerland, Germany, Italy, Portugal), in Japan, and even in Greece, which
has a poor credit history! Dismissing this phenomenon as an “anomaly” that
will correct itself with time would be too easy. Given how long negative rates
have persisted in such countries as Japan, the distinct possibility exists that
negative rates and negative bond yields could become the normal state of
affairs in the coming decades. Could we look back with nostalgia at the days
when bonds used to provide return from interest?"
Inequality is also covered.
Negative yielding bonds can be effectively seen as options on certain economic circumstances whereby the negative yield is the premium and the payout is the face value.
Of course this looks stupid at this point as it seems to go a certain kind of conventional wisdom.

minnesota nice said...

Carl - thanks for the article. According to the article, total global bond market in 2020 was $70 trillion (in dollars). For the last 5 years about 25% of these bonds trade negative!
People may complain about inflation, but they are not ready give up their bonds.
Wealth is held by aging people more concerned with loss of principal than loss of purchasing power.
Scott - in the past you have said QE does not have a real effect on rates because of the size of the global market ($70T). Is this still true with current fed actions?

Carl said...

The following is not to pick on Mr. Grannis. To put your work out to the 'universe' and share your outlook and then to stick around deserves respect.
The Fed balance sheet has been expanding drastically since the onset of the recent supply shock and The Fed has absorbed most of the issued notes and bonds since early 2020.
It's hard to suggest that these actions have not influenced interest rates (lower than they would have been otherwise). The % of Fed ownership of public debt to total public debt has gone up but it's hard to keep up with so much Treasury issuance (at least when there is no debt ceiling drama). For those who suggest that this can't go on for much longer, in Japan, the BOJ's balance sheet is now larger than GDP.
Also, the effect of the Fed open market operations have had a very large effect on mortgage rates in 2020-1 (down++). It's hard to suggest that these actions have not influenced housing prices as people have learned to agree on the price of the house they're buying based on their monthly payments.
In the November 2013 piece, it was mentioned that inflation was not an issue since most of the new money supply arose from the poorly understood Fed swap operations ("myth") that implied deposits related to matching bank reserves (money not circulating in the real economy) and i wonder why there has been such a change of heart with the new (albeit larger) swap operations.
To share the pain of 'forecast' exposure, i will say that i expect lower risk-free interest rates in the foreseeable future, likely significant within 3 to 6 months as the US starts to feel the monetary-fiscal withdrawal syndrome.

Thomas said...

Dear Scott,

I tried to find the weight of OER in a description of CPI. You are saying it is prox. 40%. Unfortunately I was not successfull.

A newsletter published by By John Mauldin, Sept 18, 2021, states:

In most areas, both actual rents and an accurately measured OER would be much higher than CPI shows. Together, those are almost 30% of the index. CPI would be running much, much higher if it reflected true housing costs.

So he says that OER is weighted by 30%. Would you be so kind to help me where your 40% are comming from?

Thank you so much!

Best regards from Austria!


Scott Grannis said...

Thomas, it's possible I misstated the %, and it could be 30%. I haven't checked in awhile. Regardless, OER is a significant part of the CPI, so my main point still stands.

Scott Grannis said...

Re: Fed's share of outstanding Treasuries and MBS: I'll be posting some chart on this soon. But here's the bottom line:

As of early 2003, the Fed owned about 20% of outstanding Treasuries and no MBS
As of the latest data, the Fed owned about 25% of outstanding Treasures and about 20% of MBS

The charts only weakly support the notion that Fed purchases have influenced the level of yields on these securities.

Carl said...

^For the CPI question:
Shelter makes up nearly a third of the basket for CPI inflation, and 40 percent of the basket for core CPI that excludes the volatile food and energy components.
What is more interesting though is the way BLS calculates and integrates this input (using OER) and there has been a divergence between OER and housing prices. Consensus seems to imply that OER will catch up but i wonder if it's not housing prices which will catch down the OER trends even with moratoriums being lifted.
What is the definition of a marginal buyer?
From early 2020 to end of June 2021, the FED bought 84% of all Treasury Notes and Bonds and about 200% of net TIPS issuance. Does that reach the definition of a marginal buyer?
In Japan, the government's role is so much taken for granted that there are days when there is no market for this huge market which has been, effectively, nationalized.