Thursday, September 21, 2023

What the Fed is overlooking


Yesterday the FOMC decided to keep its target Fed funds rate unchanged at 5.5%. That was no surprise to the market, but the tone of Powell's press conference and meeting minutes convinced the market that rates are likely to be "higher for longer" than previously expected. Market expectations are now geared to expect one more hike before year end, and only a few cuts by the end of next year. To judge by the market's reaction, there's a bit of panic in the air—maybe this time the much-feared recession that was just around the corner most of the year will finally arrive?

It's a shame that economic growth has come to be feared rather than welcomed. We've had 2% growth for over a year now, and inflation has plunged. Growth doesn't cause inflation; too much money relative to the demand for it is what does. The Fed was late to the tightening party, but they have delivered in spades. Today's high interest rates have boosted the demand for money by enough to result in a significant decline in inflation. 

It's terribly unfortunate, but the Fed worries that they haven't done enough, and that they may have underestimated the economy's strength. This tells me that the Fed is overlooking some very important developments: 1) the fact that inflation by current measures has already fallen within range of its long-term target (see Chart #7 in this post), 2) the ongoing slowdown in the growth of private sector jobs, and 3) the emerging weakness in the housing market. 

This post focuses on the housing market, which has suffered a triple whammy of soaring home prices, soaring mortgage rates, and soaring spreads over Treasuries that has combined to crush new mortgage applications, weaken housing starts and cool builder sentiment. 

Chart #1
Chart #1 shows the nominal and real (inflation-adjusted) index of national home prices according to Case-Shiller. (Note: the June figure is actually an average of April, May, and June prices). Home prices are within inches of their all-time highs, and 15% higher, in inflation-adjusted terms, than they were at the peak of the housing market boom in 2006. 

Chart #2
revise?????

Chart #2 shows the level of 30-yr fixed rate mortgages (blue), the level of 10-yr Treasury yields (red), plus the spread between the two (green). As is widely known, 10-yr Treasuries set the bar for fixed rate mortgages. In normal times, mortgage rates tend to be about 150-175 basis points higher than Treasury yields. Today, however, they are about twice as high as that (320 bps). Treasury yields have surged from 1.5% in early 2022 to now 4.4%, and mortgage rates have exploded from 3% to now 7.25%. Since the effective rate today on all outstanding mortgages is about 3.7%, anyone refinancing or taking out a new mortgage faces the prospect of a huge increase in mortgage payments on top of housing prices that have climbed to record levels. It's enough to make nearly everyone think twice. And what they're thinking is that borrowing money today is not a pleasant experience. That is how higher interest rates increase the demand for money: it's better these days to be long money than short money—in the sense that being "long" means you own it, while being "short" means you owe it. What a change from a few years ago, when I noted repeatedly that the Fed was encouraging people to "borrow and buy."

Chart #3

Chart #3 shows an index of new mortgage applications, which are down 70% from the highs of the mid-2000s, and down over 50% from the highs of late 2020. Housing market activity has been severely impacted by higher rates, and the Fed's stance today promises no relief for the foreseeable future. This is powerful evidence of an increase in money demand.

Chart #4

Chart #4 shows a measure of housing affordability, which today is as low as it has ever been, thanks to the combination of soaring home prices and soaring mortgage rates. (I would guess that the affordability of homes in the Los Angeles area would register about 60 on this chart.) 

Chart #5

As Chart #5 shows, since early last year existing home sales activity has dropped by 36%, to levels not seen since the depths of the housing market slump in 2010. Very few want to sell, and very few are able to buy. This is evidence that the housing market is unstable. Very low turnover means that prices are not a reliable indicator of value.

Chart #6

Chart #6 compares housing starts to an index of homebuilder sentiment. Both have dropped sharply from the highs of the past few years. Since early last year, housing starts have fallen almost 30%, and homebuilder sentiment has dropped by almost 50%. Over the same period residential construction spending has dropped about 10%—with further drops very likely to come in the months ahead (residential construction spending is highly correlated to housing starts, but with a lag). 

All of this is reason enough to question the overall strength of the economy. Lurking in the background are $2 trillion annual deficits fueled by excessive and wasteful government spending, the Biden administration's recent throttling of oil exploration and drilling activity, and soaring energy prices. Very expensive energy, just like high taxes, are sure-fire ways of throttling economic growth. Too much government spending is almost guaranteed to sap the economy's strength.

Conclusion: The Fed is highly unlikely to deliver on its "higher for longer" interest rate target for much longer. In coming months events are likely to transpire which will convince both the Fed and the market that inflation is lower and the economy is weaker than commonly thought. And that interest rates need to come down.

Friday, September 15, 2023

Still no boom, no bust


Back in July I ran a post titled "No boom, no bust." Things haven't changed much since then: inflation has come back down to earth, and the economy continues to grow, albeit slowly. Stocks are up a bit, the Fed tightened once, credit spreads have tightened a bit, and the market continues to worry that another Fed tightening might be the kiss of death for the economy. 

Chart #1

Chart #1 compares the level of the S&P 500 to the level of the Vix "fear" index. The two tend to move in opposite directions: rising fear levels result in lower stock prices, and vice versa. The Vix index is back down to pre-Covid levels, and stocks have been rising—though not yet to new highs. 

Chart #2

Chart #2 shows Bloomberg's Financial Conditions Index, a reliable measure of the underlying health of the financial markets and thus a forward-looking indicator of the health of the economy. Conditions are about average these days, so it's reasonable to expect the economy will continue to grow, albeit slowly (~2%). 

Chart #3

Chart #3 compares industrial production levels in the U.S. and the Eurozone. There has been very little progress in the level of industrial production since 2007, although the U.S. economy has been somewhat more dynamic than the Eurozone economy by this measure. Still, nobody's posting gangbuster numbers.

Chart #4

Chart #4 shows U.S. manufacturing production, a subset of overall industrial production. Here again we see very little improvement in recent decades. Ho-hum. But neither do we see any deterioration.

Chart #5

Chart #5 shows two measures of producer price inflation at the final demand level. This captures inflation at an earlier stage of inflation pipeline than the CPI. By either measure, inflation has fallen to less than 2%. The Fed's done. The CPI won't be far behind, except for the fact that energy prices have spiked of late—through no fault of the Fed's. Biden's Green agenda is at work here, as well as fallout from the Ukraine-Russia war.

Chart #6

Chart #6 shows two broader measures of inflation at the wholesale level (as of August). Here again we see inflation back down to where it should be: 2% or less. 

Chart #7

Chart #7 shows the 6-month annualized rate of change of the CPI compared to the CPI less shelter costs. As I and many others have been pointing out for the past several months, shelter costs have been artificially inflated as a result of the BLS using backward-looking statistics related to housing prices. 

Chart #8

Chart #9

The major component of shelter costs used in the CPI comes from what is called Owner's Equivalent Rent. As Chart #9 shows, OER is driven primarily by housing prices 18 months in the past. The chart shifts OER to the left by 18 months to correct for this. Here we see the peak in housing price inflation corresponding to the peak in OER. Since housing prices peaked over a year ago, OER is now beginning to decelerate. That deceleration is showing up very clearly in Chart #8, which looks at changes in the level of OER over 1- and 3-month annualized rates. What this means is the OER is going be contributing meaningfully to lower rates of CPI inflation in coming months. 

The FOMC meets next week, and I see no reason for them to raise rates yet again. The big question is when they will begin to lower rates. Today the market is betting on a 30% chance of another rate hike at the November meeting, with rate cuts not likely until mid-2024.

It's important to note (again) that Fed tightening this time around is fundamentally different from tightening cycles in the past. The main difference this time is that the Fed is not draining reserves from the banking system. Reserves are still plentiful at over $3 trillion. That's a huge deal. Chart #2 makes the point another way: there is no shortage of liquidity in the financial markets, unlike during periods leading up to recessions in the past. The only thing that is "disturbing" the economy this time around is that short-term interest rates are relatively high. That doesn't necessarily pose a threat to the economy. It simply makes it more attractive for people to hold money—that is, higher rates increase the public's demand for money, and that in turn neutralizes the amount of "excess" M2 that is still circulating. See this post from late August for a more detailed explanation.

Friday, September 8, 2023

Is this a great country or what?


The list of things that could be better in this country is long and distressing. But the good news is that economic conditions in the U.S. continue to improve, despite all the bad news.

Here are some charts that make the point:

Chart #1

Chart #1 shows the condition of U.S. households' balance sheet. Private sector net worth now stands at a record $154.3 trillion, almost double what it was just 10 years ago. 

Chart #2

Chart #2 shows the inflation-adjusted net worth of U.S. households. It's been increasing on average about 3.6% per year since 1952. That works out to a 12-fold increase in just 70 years. 

Chart #3

But, you say, the population has also increased a lot over that same period. So Chart #3 adjusts the data for Chart #2 by population, which has roughly doubled since 1950. Here also we see steady and impressive growth in inflation- and population-adjusted private sector wealth. By that measure, and as a rough approximation, the living standards of the average American have increased by a factor of almost 6 in the past 73 years. 

Chart #4

It's outrageous that our federal debt as a percentage of GDP is almost 100%. It was about 60% in the early 1950s, then it fell to a low of about 25% in the mid-1970s, and since 2007 it has increased from just over 30% in 2001 to 95% now. Fortunately, the private sector has de-leveraged significantly—by about 40%—since 2007, as Chart #4 shows. It's now back down to where it was in the early 1970s. 

Wednesday, September 6, 2023

The economy is NOT "running hot"


Today bond yields rose and the stock market swooned, as the market was apparently spooked by some stronger-than-expected statistics coupled with the Atlanta Fed's GDP Now forecast of 5% growth in the current quarter. The fear is that the economy is "running hot" and that will prod the Fed to keep rates high (or higher) for longer, in order to lower the economy's temperature—possibly triggering a recession at some point. My read of the data and other key indicators suggests nothing of the sort.

Chart #1

Chart #1 shows the ISM Service Sector Index. While it has ticked higher in recent months, it is still below the levels leading up to the Covid shutdowns, during which time the economy was experiencing relatively modest growth on the order of 2% per year. No boom here and no bust either.

Chart #2

Chart #2 shows the Business Activity component of the overall index. Here too we see an uptick in recent months, but activity is still somewhat less strong than we saw in the latter half of the 2010s. If anything, I'd say this looks like "steady as she goes."

Chart #3

Chart #3 shows the employment component of the Services index. Same story as the others. A modest increase in the number of firms reporting increased hiring activity, but nothing to suggest a boom that needs to be snuffed out.

Chart #4

Chart #4 shows a modest increase in the number of firms reporting paying higher prices. This comes after a gigantic decline over the previous year which corresponded closely with a similar decline in overall inflation. Does the recent uptick foreshadow a return of higher inflation, or is it just a wiggle such as we have seen on and off over the years? I'd have to see rising prices showing in other areas to believe this is of concern. Instead I see most commodity prices flat to down, and housing prices sharply lower than a year ago.  (And of course it bears repeating that the ex-shelter version of the CPI has increased only 0.8% in the past year.) The major exception is rising oil prices which are likely being driven by ongoing problems with Russia's Ukraine-related sanctions. I also see a stronger dollar which is the very antithesis of inflation. 

Chart #5

Chart #5 compares the U.S. service sector index (same one as shown in Chart #1 above) with a similar index measuring the health of the service sector in the Eurozone. The Eurozone is hurting, that's for sure, and so is China. It's tough to see how widespread weakness overseas is going to foster inflationary growth conditions in the U.S. In addition, a strong dollar—driven by rising rates— actually reinforces disinflationary pressures here, since it makes imports cheaper and keeps downward pressure on export prices. If the Fed raises rates yet again, that would likely drive the dollar still higher and that in turn would begin to create destabilizing forces overseas. 
 
Chart #6

Chart #6 shows the spread between the yield on investment grade corporate bonds and their "junk" rated counterparts. This spread is saying the prospects for the U.S. economy are quite favorable (since the spread is unusually low), because investors demand only a relatively small premium to take on the additional credit risk of junk bonds. This is notable especially now, coming on the heels of an impressive increase in corporate debt issuance. Despite increased debt supply, corporate bond yields have not increased in any meaningful fashion. That further suggests that there is no shortage of liquidity in the bond market, and that all but rules out a near-term recession.

I'll repeat once more that the unique characteristic of the Fed's current tightening episode is the continued abundance of bank reserves, which currently total over $3 trillion. All other tightening episodes saw a deliberate contraction in bank reserves (banks actually had to borrow reserves to meet their collateral requirements), and that in turn led to a scarcity of liquidity in the banking system. With lots of liquidity the market is capable of adjusting to almost any kind of disruption. That wasn't the case in prior tightening episodes. Interest rates may be high but there is no shortage of money.

Chart #7

Chart #8

Chart #7 shows an index of new mortgage applications, which are down over 50% since early 2021, and down about 70% from the days of the housing market boom in the mid-2000s. Chart #8 shows an index of housing affordability, which has reached a 33 year low. Higher interest rates have had a huge impact on the housing market, driving resale and refi activity sharply lower, all while making housing unaffordable to legions of households. If any sector of the economy is at risk of a bust, it's housing. 

Housing is also suffering from an effective liquidity shortage. Homes for sale are at very low levels because 1) sellers don't want to give up their 3% mortgages and 2) buyers don't want to take on a 7% mortgage. With very low turnover no one can be sure that current home prices are indicative of underlying value. Moreover, desperate buyers are likely to pay more than they can afford and are thus vulnerable to a recession or any downturn in prices. This is probably the worst time in many decades to buy a house.

Friday, September 1, 2023

Of concern: jobs growth is slowing


I spend a good part of most days following the news and key economic and financial market indicators. When I see Fed governors quoted as saying things like "the labor market is still strong," or "inflation is still too high," I begin to wonder if they even bother to look at the numbers themselves. I suspect they don't devote nearly as much time and effort as I do. Which is disconcerting, to say the least. 

In the same vein, how can the editors of the WSJ allow a front-page article in today's edition to assert that "Household spending [is] the primary driver of economic growth"? You mean that if we all just spent more we could all get richer? That's ancient and totally debunked Keynesian thinking—it's impossible to spend our way to prosperity. Growth comes from producing more with the same amount of inputs, and to do that you need to work harder, invest, and take risk. Or you need to find more people and put them to work. On a global basis, we can never spend more than we produce—unless, of course, central banks hand out monopoly money to create the illusion that our purchasing power has increased. 

Chart #1

Chart #1 shows the level of private sector non-farm employment, plotted on a log scale to highlight growth rates. I focus on private sector jobs because those are the ones that deliver improvements in our standard of living. As a side note, the number of public sector jobs today is about the same as it was in 2008, 15 years ago. Thank goodness for small favors.

As you can see on the chart, the rate of growth of jobs has been decelerating over the past few years (i.e., the slope of the line is getting flatter). On a year over year basis, private sector jobs were growing at a 4.8% rate a year ago (August 2022), whereas they have grown only 2.0% in the year ending August 2023. On a 6-mo. annualized basis, jobs growth was 3.4% a year ago, and now it is only 1.5%. Based on these numbers, it would be fair to say that in the past year the economy has lost over half of its vitality.

Jobs today are growing at about the same rate as they did in the years just prior to Covid, and they show every sign of continuing to decelerate. This is by no standard "too strong." It's more like average-getting-worse. Today's jobs growth is sufficient to deliver real GDP growth of 3% at best, but more likely something equal to or less than the 2.1% rate we have seen since mid-2009—years that featured decidedly sub-par growth from an historical perspective. 

How can a Fed governor look at these numbers and think that the economy is too strong? If anything, these growth numbers should prompt concerns that the Fed has already tightened too much. Especially when you consider, as I did in my previous post, that inflation has already fallen to 2% by some measures.

Wednesday, August 30, 2023

2% growth and 2% inflation: the Fed's done


This brief post highlights some under-appreciated news contained in today's revised estimate of Q2/23 GDP. Real growth in the quarter (annualized) was revised down from 2.4% to 2.1%, and inflation (according to the all-encompassing GDP deflator, also annualized) was revised down from 2.2% to 2.0%. We're very much in a 2% growth world, as I noted last May. Inflation, meanwhile, has plunged from a high of 9.1% a year ago to a mere 2.0%.

These facts lay bare the false belief that inflation is the by-product of an economy that is "running hot," and that in order to bring inflation down the economy must suffer a period of "below-trend" growth. It just doesn't work that way. The economy has been growing at a sub-par rate since 2009, while inflation has been all over the map. Inflation is the result of too much money relative to the demand for money. 

These facts also highlight just how wrong the market is to worry that the economy is "too strong" and therefore the Fed must keep short-term rates at a high level for an extended period. I see the 3.4% rally in the S&P 500 over the past 12 days as evidence that the market is just beginning to appreciate these facts. 

Chart #1

Chart #1 shows the path of real GDP compared to two different trend lines. (Note: the y-axis uses a semi-log scale which shows constant rates of growth as straight lines.) The 3.2% trend was in effect from 1955 through 2007, while the 2.1% trend has been in effect since mid-2009. This highlights the grim reality that the U.S. economy has been suffering from a prolonged period of sub-par growth, thanks mainly to unusually high regulatory and tax burdens, coupled with excessive government spending, which in turn has been driven primarily by transfer payments (i.e., sending out checks to people without demanding any work in return).

Chart #2

Chart #2 shows the quarterly annualized rate of growth of the GDP deflator—the broadest, most inclusive, and most timely measure of inflation that we have. (Most folks seem to prefer a narrow, year over year measure of inflation, which is guaranteed to obscure important changes on the margin.) Why don't you see this 2% number in the press? Why is the Fed bemoaning the fact that inflation is still "too high?" Go figure.

One thing for sure: it's only a matter of time before the Fed realizes that instead of keeping rates high for longer, it's time to bring them back down.

P.S. (8/31): Don't forget that as of July, the CPI ex-shelter index was up only 0.85% year over year. See Chart #2 at this post. Shelter costs are almost certain to decline in coming months since they lag the housing market by about one year. And as Chart #3 shows (below), durable and nondurable goods prices have been flat to down over the 12 months ending in July, leaving services (which includes shelter costs) as the only source of inflation.

Chart #3



Wednesday, August 23, 2023

The most important variable that won't be discussed at Jackson Hole


Today's Bloomberg headline: "Powell to map final steps in inflation fight at Jackson Hole." Memo to Fed: the fight is over. You won. 

Central bankers meeting this week in Jackson Hole likely will be talking about everything BUT what matters the most: the balance between the supply and the demand for money. Incredibly, our central bankers have failed to notice the monetary elephant in their living room for the past 3+ years. 

I've been writing extensively about money in the Covid era since October 2020. As I noted back then, strong growth in M2 in 2020 was driven by a huge increase in money demand. That's why rapid M2 growth wasn't inflationary in the beginning. 

Inflation didn't start showing up until 2021, when Covid fears began to ease and the economy began to get back on its feet. Rising confidence meant that people no longer needed to hold tons of money in their bank accounts. Declining money demand at a time of abundant M2 unleashed a wave of inflation. It wasn't until a year later—March '22—that the Fed (very belatedly) took steps to bolster the demand for money by raising short-term interest rates. Sharply higher interest rates over the past 16 months have had their intended effect: the public has become much more willing to hold on to the huge excess of M2, even as excess M2 has been declining. Falling inflation is the result. Money supply and money demand have moved back into rough balance.

Contrary to all the hand-wringing in the press (e.g., will the Fed need to crush the economy in order to bring inflation down?), and as I've been arguing for months, inflation has all but disappeared, even as the economy has remained healthy throughout the tightening process. 

There is still plenty of money in the economy. This tightening cycle has been very different from past episodes, because this time the Fed has not had to shrink the supply of bank reserves. As a result, there is still plenty of liquidity in the market. Swap and credit spreads are correspondingly low, and that implies little or no risk of a recession for the foreseeable future.

Markets are on edge, worrying that the Fed will need to keep rates very high for a long time to come. Those fears are misplaced. It won't be long until both the market and the Fed realize that lower interest rates have become the big story.

Some updated charts that incorporate yesterday's M2 release for July:

Chart #1

As Chart #1 shows, the M2 money supply continues to follow a path back to its long-term trend (6% per year since 1995). The "gap" between M2 today and where it would have been in a more normal world has fallen by half since its peak in late 2021. Excess M2 supply is declining at the same time as M2 demand has increased thanks to aggressive Fed rate hikes. This implies reduced inflation pressures—which is exactly what we have been seeing. 

Chart #2

Chart #2 shows the amount of US currency in circulation (this includes all the $100 dollar bills circulating in Argentina as well as in other countries with unstable currencies). Currency in circulation is an excellent measure of money demand, since unwanted currency is easily converted into interest-bearing deposits at any bank. People hold currency only if they want to hold it. Slow growth in currency is telling us that the demand for money is easing—but not collapsing. According to this chart, currency in circulation is only about $70 billion higher than it might have been had the Covid shutdowns and massive government spending not occurred (the 6% trend line has been in place since 1995). 

Chart #3

Chart #3 compares the growth rate of M2 to the level of the federal budget deficit. It's quite clear from this chart that $6 trillion of government "stimulus" spending was monetized. It's also clear that even as the deficit has again been rising, M2 continues to shrink. Rising deficits do not pose a risk of rising inflation this time around—at least so far. Rising deficits are being caused almost exclusively by excessive government spending, and that is the problem going forward. Government spending squanders the economy's scarce resources and saps the economy of energy by weakening productivity growth. 

Chart #4

Chart #4 compares the growth of M2 to the rate of inflation according to the CPI. Note that CPI has been shifted to the left ("lagged") by one year. Thus, changes in M2 growth are reflected in changes in inflation about one year later. Slowing growth in M2 is beating a path to lower inflation. 

Friday, August 18, 2023

TIPS vs Gold: which is the better inflation hedge?


TIPS and gold are widely considered to be classic inflation hedges, but they couldn't be more different. TIPS (Treasury Inflation Protected Securities) look far more attractive than gold these days, since they are not only an inflation hedge but also a deflation hedge and a hedge against an economic slowdown or recession.

Here's how they stack up against each other on key attributes:

Guarantees: Gold promises to keep up with inflation over long periods, but there is no guarantee this will happen, especially over shorter periods. TIPS, on the other hand, are guaranteed by the US government to keep up with inflation—and then some, due to the 2% real yield they currently pay on top of whatever inflation is registered by the CPI. Arguably, TIPS have an additional benefit since they are tied to changes in the CPI, which tends to overstate inflation over time (by about 0.5% per year according to most estimates).

Holding costs: Gold pays no interest and costs money to store. TIPS pay a guaranteed real rate of interest and their principal is adjusted for inflation continuously—and since TIPS are Treasuries, they are default free. Owning TIPS at a typical brokerage firm costs virtually nothing (there several ETFs which invest exclusively in TIPS as well).

Recent price action: The recent bout of high inflation has fueled demand for gold, which has risen about 25% in the past three years. In response to rising inflation, the Fed has tightened monetary policy significantly, boosting 5-yr real yields (the benchmark for most TIPS investments) from a low of -2% to +2.2% in the past two years, thus reducing the price of 5-yr TIPS by about 20%.

Background: The level of real yields is the best measure of how "tight" or "loose" monetary policy is: the higher the tighter, the lower the looser. Tight money is always associated with high real rates, and thus low TIPS prices. You can read detailed explanation of the mechanics of TIPS here

And now for some charts:

Chart #1

Gold is expensive. Chart #1 shows the inflation-adjusted price of gold from 1913 through today. Gold was worth about $19/oz back in 1913; in today's dollars that would be about $600/oz as shown in the chart. From an historical perspective, gold is pretty expensive. Today it is only about 20% below its all-time high in today's dollar terms (~$2400/oz in 1980), and it's up some 580% from its all-time low (~$280/oz in 1970). Over the past 110 years, gold in today's dollars has averaged about $780/oz. It'w worth 140% more than that today. 

Chart #2

Chart #3

Real yields tend to track gold prices. As Charts #2 and #3 show, TIPS and gold prices tend to move together—but not all of the time. Chart #2 compares the prices of 5-yr TIPS (using the inverse of their real yield as a proxy for their price) to the prices of gold in today's dollars. Chart #3 uses a shorter time frame and nominal gold prices instead of real gold prices. Chart #2 starts in 1997 because that's when TIPS were first introduced.

The first anomalous period was in the 2000s, when TIPS prices soared and gold lagged but finally caught up. We might say that in this period, real yields were leading indicators of gold prices. The second anomalous period began early last year, as TIPS prices fell (driven down by tighter Fed policy) and gold prices held relatively steady. The question today is: will gold prices eventually fall given the high level of real yields? I think there's a good chance of this happening, especially if the Fed stays too tight for too long. But if not, then we're likely to see real yields fall as the Fed eases, thus driving the two prices closer together.

TIPS are cheap, given the high level of real yields which in turn are driven by tight Fed policy. The Fed is tight because they want inflation to fall. But as I've been pointing out for the past several months, inflation is falling and is very likely to continue to fall; by some measures it's fallen well into the range that should make the Fed happy. The Fed and the market seem to be overlooking this key fact, but sooner or later it will become blindingly obvious that inflation has been tamed. That should prompt the Fed to ease, and real yields to fall, thus boosting TIPS prices.

In summary: Recent high inflation has driven demand for gold to historically high levels. Meanwhile, Fed tightening has pushed real yields sharply higher (and TIPS prices lower). Gold is vulnerable to lots of downside risk in a low and stable inflation environment (such as we're likely entering) and is far more volatile in price than TIPS. TIPS have upside price potential if the Fed eases, and their downside risk is limited by how much the Fed can tighten. If real yields were to rise to 3-4% on top of inflation, TIPS become compelling and relatively safe alternatives to equities. Every time real yields have risen to 3-4% or more, the economy has suffered a recession and the Fed has eventually eased.

Conclusion: Gold is exposed to the threat of high real rates and the likelihood that inflation will soon fall to the Fed's target, if not lower. TIPS are a deflation and recession hedge because either event will force the Fed to ease, thus lowering real rates and boosting TIPS prices. TIPS are an attractive and guaranteed inflation hedge since they offer a government-guaranteed real yield in addition to having their principal continuously adjusted for inflation. 

Sunday, August 13, 2023

A look inside the inflation numbers says the Fed is done


I've long believed that the Fed and most media observers are confused about how inflation works. That's because most people are still captive to the traditional Phillips Curve model of inflation, which says that in order to tame inflation, the economy needs to suffer a significant slowdown in growth. In turn, that means that the Fed needs to be very tight for a significant period; no easing until early next year. 

So the market is convinced the Fed will be on hold through at least the end of the year. But a look inside the inflation statistics suggests that is likely to be unnecessary; inflation is very likely to continue to decline in the months to come. At some point, likely well before year end, the Fed is going to have to concede that inflation has been licked—and lower rates accordingly. 

And now for some charts:

Chart #1

Chart #1 shows the quarterly annualized rate of inflation according to the GDP deflator. This is the broadest and most inclusive measure of inflation that we have. In the second quarter prices throughout the economy rose at a mere 2.2% annualized rate—exactly in line with the Fed's target. Why is no one else talking about this? To me, it's abundantly clear that inflation is yesterday's news. Inflation is more likely to decline further than it is to rise. 

Chart #2

Chart #2 looks at the 6-mo. annualized growth of the Consumer Price Index with and without shelter costs, the latter of which comprise over one-third of the total. I've been highlighting this for a long time: shelter costs are notorious for measuring housing prices and rents with a lag of one year or more. Absent shelter costs, the CPI over the past six months is up at a teeny-tiny annualized rate of only 0.6%! Including shelter costs, the CPI over the past six months is up at a 2.6% annualized rate, which is only slightly above the Fed's 2% target. (Actually, the Fed is targeting 2% for the PCE deflator, which is equivalent to about a 2.5% CPI.) Why all the anguish about inflation "still running hot?" 

Chart #3

Chart #4

It's well-known that housing prices and rents stopped rising about a year ago, but owner's equivalent rent, the largest single component of the CPI (red line) is still rising, albeit at a somewhat slower rate in recent months. As Chart #3 shows, OER lags changes in housing prices by about 12-18 months. As Chart #4 shows, OER inflation has been falling—and it will very likely continue to fall for the next 6-9 months. Before the year is out, OER disinflation might well be enough to cause the overall CPI to turn negative.

Chart #5

Chart #5 shows the three major components of the Personal Consumption Deflator, which increased by 3.0% in the year ending June. Note how both the non-durable goods and durable goods indices have been unchanged since June of last year. This means that the only source of inflation in the economy since June of 2022 has been in the service sector. Shelter costs figure prominently in this sector, just as they figure prominently in the CPI. Shelter costs are badly measured; correcting for that we find that inflation is no longer a problem.

Chart #6

Chart #6 shows the percentage of businesses who report paying higher prices, according to the ISM survey. Only 57% reported paying higher prices in July, and that is about the same number that reported paying higher prices in the year prior to Covid. In short, we're back to where we started on inflation.

Chart #7

Chart #7 shows the nominal and real yields on 5-yr Treasuries and TIPS, and the difference between them (green line), which is the market's expectation for what CPI inflation will average over the next 5 years. By this measure, the bond market fully expects the Fed will deliver on its inflation promise: 5-yr inflation expectations are about 2.2%. 

Chart #8

Now let's turn to the economy. Contrary to the hand-wringers who lament that the economy is "running hot" and thus we're unlikely to see further declines in inflation, Chart #8 (monthly changes in private sector jobs) makes it clear that the growth of private sector jobs has been declining since early 2022. The private sector is the one that counts, and jobs there have grown by only 2.2% in the past year. That's down sharply from the 5.0% year over year growth rate through July '22. Over the past six months, private sector jobs have increased at only a 1.6% annualized rate. Judging by the jobs market, the economy is unlikely to do much better than 2% going forward. That's not even close to "running hot" in my book.

Chart #9

Chart #9 compares the level of inflation-adjusted GDP (blue line) with two trend lines (green and red dashed lines). It's plotted on a log scale axis, which means constant rates of growth show up as straight lines. Here we seen that since the summer of 2009, the US economy has grown on average by about 2.1% per year. That's way less than the 3.1% growth trend that prevailed from 1965 through 2007—21% less, in fact. If the economy had followed a 3.1% trend growth path, it would be 26% larger today. We live in a slow-growth world, thanks to massive (and terribly wasteful) government spending on transfer payments and inefficient "green" energy.

Economic growth has been sluggish for the past 14 years, yet that didn't stop inflation from rising to double-digit levels. That's because growth has nothing to do with inflation; inflation is all about money. By sharply boosting short-term interest rates since early last year, the Fed has managed to bring money supply and money demand back into line, and that is why inflation has fallen. 

M2 growth has slowed dramatically and inflation has fallen because interest rates have soared. Higher interest rates make holding money more attractive, AND they make borrowing money less attractive. The public today is more willing to hold onto M2 and less willing to spend it. The public is less willing to borrow money since interest rates are so high and more willing to pay back existing loans. (Banks create M2 money when they make net new loans.) The result is a balancing of the supply of money and the demand for money, and the gradual disappearance of inflation.

Currently, the market expects the Fed to hold rates steady through the early part of next year, and then to begin easing. If my reading of the monetary and inflation tea leaves is correct, the Fed should begin cutting rates now, not next year. If they wait too long, we will see the CPI entering negative territory (i.e., deflation). 

Would deflation be a huge problem? Many seem to think so, but I'm not so sure. The argument against deflation is that consumers would pull back on their spending—and weaken the economy—because cash would become an earning asset. Why buy something now if you can buy it later with fewer dollars? The problem with this line of thinking is that economic growth does not depend on consumers spending money. We don't spend our way to prosperity, we work hard and invest in order to prosper.

Growth is the by-product of savings and investments that boost the productivity of the average worker, in addition to the organic growth of the workforce. For example, and roughly speaking, a 1% increase in productivity plus a 1% increase in jobs results in real economic growth of 2%.

Be patient. Sooner or later the numbers will convince the Fed that lower rates are called for. In the meantime, enjoy an economy that continues to grow, albeit relatively slowly, and inflation that continues to decline.

P.S. Two days ago we returned from a two-week family vacation in West Maui (Napili Bay, to be precise). If you've been following the news, you know that last week an unimaginably disastrous tragedy befell Lahaina, which is about 8 miles south of Napili. Although we suffered no harm, we were without electricity and communications with the rest of the world for 3+ days. Our hearts and prayers go out to those (several of which worked at our hotel) who lost their homes, friends, and family members.

Tuesday, July 25, 2023

M2 update: inflation still headed to zero


On the eve of what is likely to be the end of this cycle of Fed tightening (even if the Fed hikes rates 25 bps tomorrow, they will almost surely convey the impression that no more hikes are envisioned), this blog continues its coverage of the all-important money supply figures. The June M2 number was released today and it was unremarkable. Year over year M2 growth is running at about a -4% rate, while M2 has been relatively flat over the past three months. This is consistent with further declines in inflation over the next 6-9 months.

It continues to amaze me that only a handful of Fed watchers pay any attention to the M2 money supply. The vast majority of inflation-related commentary—including that of the Fed itself—lavishes attention on just about every inflation indicator and variable except the money supply. Milton Friedman must be rolling in his grave. As he famously said, "inflation is always and everywhere a monetary phenomenon." Inflation happens when the supply of money exceeds the demand for it, and the lags between money supply and inflation are "long and variable." So when the US M2 money supply grew at a 20-30% annual rate in 2020 and early 2021, a big increase in inflation was very likely to show up in early 2022. And, not surprisingly, it did. 

We've now seen M2 growth not only collapse, but actually turn negative over the past two years. Again, not surprisingly, inflation began to decelerate dramatically starting about one year ago. More recently, M2 growth has been flat for the past three months, so to the extent that some observers, like Brian Wesbury, worry that collapsing M2 portends an eventual recession, the M2 news has become much less worrisome. 

Chart #1

Chart #1 shows the level of M2 relative to its long-term trend growth rate of 6% per year. (Note that the y-axis is plotted on a log scale, so a straight line represents a constant rate of growth.) M2 is still about $2.6 trillion above trend. I've interpreted this to mean that there is still a lot of liquidity in the economy, and this should act as a buffer against adverse developments. 

Chart #2

Chart #2 compares the year over year growth of M2 with the rate of consumer price inflation, with the latter shifted to the left by one year to illustrate the fact that there is approximately a one-year lag between changes in M2 growth and changes in inflation. The chart strongly suggests that the CPI is on its way to zero over the next 6-9 months. As such, it's reasonable to conclude that the Fed has acted appropriately, if belatedly, and no further tightening is therefore necessary; lower inflation is "baked in the cake" at this point. 

Chart #3

Chart #3 compares the growth rate of M2 with the 12-month running sum of monthly federal budget deficits. This chart strongly suggests that most or all of the deficits from 2020 through early 2021 were monetized. In other words, the massive Covid-era spending blowout was financed with money that was effectively printed. Fortunately, the rising deficits we have seen in the past year have not been monetized, so there is no reason to worry about a resurgence of inflation fueled by excess M2 growth.

Chart #4

Chart #4 shows the Conference Board's index of consumer confidence. July's figure was reported today, and it showed a welcome increase. This supports my long-held contention that there is no reason to worry about an imminent recession. The economy is likely to continue growing for the foreseeable future, albeit at a relatively unimpressive rate of 2% or maybe a bit less.