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Unfortunately, the Fed hasn't yet figured this out, but I strongly suspect they will before too long. Meanwhile, standing pat, as the FOMC did today, is the least worst alternative to easing. Interest rates are relatively high from an historical perspective, but there are as yet few—if any—signs that monetary policy is too tight or that it is threatening the health of the economy. The fact that the year over year change in the CPI (now 4.0%) is still above the Fed's 2% target is meaningless, when a look under the hood shows that this measure of inflation will almost certainly fall to 2% (or lower) within the next several months.
Chart #1
Chart #1 compares the 6-mo. annualized change in the CPI to the same change in the CPI less shelter costs. According to the latter, inflation has already fallen to 0.8%. As I have been arguing for the past several months, the measure of shelter costs (e.g., rents) used in the CPI lags the reality of the housing market by about 18 months. In the real world, housing prices have not increased at all over the past year, but the CPI is assuming they have been rising. So removing shelter costs from the CPI is entirely legitimate. Without shelter costs artificially inflating the CPI, inflation would already by significantly less than the Fed's target. And if that doesn't convince you, then look at the fact that over the past six months, the CPI has risen at only a 3.2% annualized rate, and it's almost guaranteed to fall further by the end of the year as shelter costs turn negative.
Chart #2
Chart #2 shows the 6- and 12-mo. annualized change in the Producer Price Index for Final Demand. This index is comprised of things that inhabit the early stages of the inflation pipeline, and here we see that inflation is already comfortably below 2%.
Chart #3
Chart #3 compares the value of the dollar (inverted) to the inflation-adjusted price of crude oil. Two things to note: commodity prices have a strong tendency to move inversely to the value of the dollar—a stronger dollar tends to push commodity prices down, and a weaker dollar tends to push commodity prices up. Today the dollar is relatively strong vis a vis other currencies, and commodity prices are generally weak. Crude prices are down almost 40% since last summer's peak, and the CRB Raw Industrials index (a broad measure of non-energy commodity prices) has fallen to levels which prevailed over a decade ago. In real terms, oil today costs about half of what it did a decade ago. Cheap energy can be a powerful tonic promoting economic health.
Chart #4
Chart #4 compares the real Fed funds rate (the true measure of how high interest rates are) to the slope of the Treasury yield curve. Note that every recession on this chart was preceded by a huge increase in real interest rates (blue line) and a significant inversion of the yield curve (red line). Today the yield curve is definitely inverted, but real interest rates are not yet punishingly high, so by this criteria a recession is not yet baked into the cake. And as I've noted in prior posts, credit and swap spreads are still quite low, which also suggests that recession risk is low.
Chart #5
Chart #5 compares the level of the S&P 500 (blue line) to the level of the Vix (fear) index. Here we see that the market has been moving up from its low of last September at the same time that the Vix index has been declining from 31 to now only 14. Fears are subsiding and the stock market is breathing a sigh of relief. The market knows it is only a matter of time before the Fed wakes up and starts easing.
49 comments:
Scott,
This is the first day the tape agrees with your thesis. Bonds aren't running away from the data. The path is north for prices
Debits to DDs are much higher than debits to TDs. DDs have increased by 17% relative to TDs since Covid-19. So, velocity is higher (the demand for money is lower).
CPI and PCE for that matter have been slower to move than hoped/predicted by the "experts" in the economics/banking professions for at least a couple of years now. However, we are now at a point where Fed Funds is 5 and CPI is 4, so it would seem that all or most measures of tightness are fairly high. The fed is playing the lag time vs rate level tradeoff game. They are giving some time for their actions to spread through the economy (and markets).
There is a significant chance of a recession, but it could be pretty mild. It would be better in the long run to have a recession. If not, I think the trajectory for things we got from ~2003-2007 might be in place. Even more speculation, if that's possible, and then a very painful recession.
If it takes until 2030 to get at least a moderate recession, it will be very painful. That recession would run into the Social Security insolvency problem, which could be the biggest financial issue since the 1930s.
Thanks Scott. I think JP (above) would benefit from an update to the big M2 chart. "Transitory" was never the right word for this bout of inflation, but that doesn't mean there was a clear cause. And that cause is slowly subsiding. Everything else Scott provides in these posts is VERY helpful color around an otherwise simple story explained fully by M2 spiked with Covid payments.
To better appreciate this post, I'd recommend readers revisit this post: (http://scottgrannis.blogspot.com/2023/05/a-soft-landing-thanks-to-surplus-m2.html) which features M2 (fueled by Covid payments) as the cause of our current inflation, plus the interplay with money demand. It also explains why the risk of inflation is relatively low, thanks to the fact that we still have a lot of M2 that can act as a cushion.
As for the apparent stickiness of Core measures of inflation, that is best explained by the way shelter costs are calculated. Shelter costs always lag the reality of housing prices by a considerable amount. Prices have been falling for almost a year, but shelter costs in the CPI have continued to rise. That will reverse very soon, and that will be the main impetus for a big drop in Core measures of inflation.
"risk of inflation is relatively low, thanks to the fact that we still have a lot of M2"
I think you meant "risk of recession .."
What is more perverse: raising rates a little too high to make sure inflation goes back down, yes maybe to zero instead of the magic number of 2%?, or, every time there is a crisis, bailing out borrowers with inflation - at the expense of the middle and lower classes?
Scott certainly deserves credit for speaking against the Fed's accommodation of the fiscal inflation in the last go-around (covid), but there is an argument now for not just reining in the inflation rate, but actually deflating - slowly - and giving value back to the middle and lower classes. Yes, even at the expense of some temporary job loss.
More important though is to STOP bailing out - during the next inevitable crisis - all the leveraged interests out there (hedge funds, private equity, real estate, and every other finance playground).
We can't keep having these merry go rounds every time - borrowers get bailed out and the lower classes lose their savings (inflation). (Maybe someday a leader will articulate this to the American middle classes so they finally understand what is going on)
I know some of you out there will say that there was no inflation during the whole QE after 2008, but I think this is incorrect. QE "locked in" all the inflation created by the banks that led up to 2008. In other words the inflation happened earlier with bad bank loans pumping things up, and the deflation that normally would have happened after the bust was prevented by the Fed re-leveraging the system. The Fed locked in all the bad decisons by banks.
Richard, I totally agree with you re government bailouts which most certainly help those who need it less than those who do. BUT, DC being what it is, you know damn well it will continue. No amount of cajoling and explaining will prevent a politician from spending more. Also, I agree that the Fed should err on the side of too much rate hikes than too little but in this case the pause was right. Sit and wait to see if inflation moderates more before perhaps raising unnecessarily. Time will tell.
Scott, your ability to filter through the economic forest is remarkable, to wit: Soft landing due to surplus M2.
The problem is that Jerome Powell thinks banks are intermediaries. That’s why the FED uses interest rates as its monetary transmission mechanism.
Powell: “When times are good in the economy, banks and other lenders tend to have a lot of money to LEND. And in case you didn’t realize, banks are in the business of making money off of loans. So if they can LEND to more people who they believe will pay them back on time, they’ll make more money.
But right now it’s costing banks more to get the funds they need to make loans. Part of that goes back to the Fed’s interest rate hikes. But the other part comes from the recent bank failures. Since many depositors withdrew money from mid-size and regional banks, these banks have less money to LEND.”
THE MONEY STOCK IS NOT SYNONYMOUS WITH SAVINGS.
Richard H: you are correct. I meant to say “the risk of recession is relatively low.”
Thanks for spotting that.
Excellent, Scott. Yes, a pause was definitely the "least worst" thing the Fed could do if they didn't cut rates. The focus on housing and shelter is the correct focus. This is where a major source of the inflation and problem is. We need more supply of housing, not less. The Fed's increase in interest rates to levels that are excessively high compared to the last 15 years are completely contrary to promoting more housing/shelter supply.
The reason that inflation is declining is not because of the Fed, but because we have a remarkable capitalist system with incredibly smart and talented people who can allocate resources to where there is demand. That system was prevented from properly working as a result of the pandemic and disruptive government policies. It is now almost back to normal. The Fed just needs to get out of the way and not do anything stupid or extreme. (Ditto for the federal government and things like trillion dollar stimulus packages.) Short rates should be closer to 3.0%. We don't need more needless bank failures. We do need more housing supply, not less.
re: "We don't need more needless bank failures"
Banks don't lend deposits, yet the banks need a positive balance of payments in order to operate. That was the reason for Reg. Q ceilings in the first place. And the NBFIs are the DFI's customers. The world's economies are run in reverse.
re: "We do need more housing supply, not less"
Bernanke bankrupt half the home builders. That dropped housing starts.
https://fred.stlouisfed.org/series/HOUST1F
This problem requires government intervention, incentives to build affordable housing. And disincentives for oligarchic speculation.
The transaction’s velocity, debits to deposit accounts, of money seldom falls. It did during the S&L crisis and during the GD. But monetary policy must remain tight today, tomorrow, and for as long as it takes to drive down N-gDp.
The demand for money is dropping at an historic rate. With FedNow (instantaneous payments) starting in July, velocity is likely to stay high.
"incentives to build affordable housing"
The long term chart on housing starts is the most important chart for the Fed to be looking at. It is so obvious that there is such a deficit that resulted in the aftermath of 2008.
We don't need incentives to build affordable housing. We just need to let the markets function somewhat normally so that all types of housing supply can be added, as we saw for most of the period form 1960-2007. Incentives for affordable housing end up distorting the market and make "middle market" housing and every other type of housing more expensive, and therefore counterproductive.
Housing- a great indicator for what is dysfunctional in the US economy for several decades.
Adjusted for population, new housing construction has been on a significant downward slope for decades, and did indeed get smashed after the 2008 recession: (now about 30% below average long term levels!)
https://fred.stlouisfed.org/graph/?g=16eGX
Problems:
1. Housing is the ultimate "real economy product" for the retail/consumer/public.
2. The labor market has made it difficult to attract skilled trade people to construction careers (low pay because of globalization of labor markets- immigration and off-shoring causing lower wages for all non-college-required jobs in the US)
3. Younger generations impacted by this lower pay (ripple effect of blue collar job market) so, the demand is not there for first time buyer homes
The typical dysfunction caused by government intervention (of finances, labor markets- indirectly by allowing unfair competition, basically).
We do need a better functioning housing/construction market.
The administrations initiatives are ineffective:
https://www.whitehouse.gov/briefing-room/statements-releases/2023/03/09/fact-sheet-president-bidens-budget-lowers-housing-costs-and-expands-access-to-affordable-rent-and-home-ownership/
"The administrations initiatives are ineffective:"
Government solutions = 1. focus on the symptoms, not the root cause 2. regulation (e.g. subsidies for which compliance needs enforcement/policing) ... result is that the root cause remains and a costly police state approach is created.
The current model: maximize GDP, with income equality (= low/middle income people barely make it- almost require social welfare), raise taxes (on higher income), redistribute the income.
Better= make markets more fair, e.g. other countries have many trade violations, with dumping, labor and other regulatory practices which are inferior and cheaper than in the US. Cheap labor from immigration to the US is also significant. Create a trade framework with incentives and penalties to these countries, better control our own immigration, and watch the low and middle income labor market improve significantly in the US.
Then people would have the ability to pay for things like more housing. Supply will respond.
wkevinw (by the way, what does that mean?): so true about immigration. For the sake of cheaper wages - where EVERYBODY looks the other way (as to illegal employment) - we are importing millions of people decade after decade to do our physical work. Unlike cheap goodies from China that could end tomorrow theoretically, we are, through illegal immigration, creating HUGE social problems down the road (i.e their children will not want to do the same work, so we need to keep importing). It was one thing to encourage immigration to the US in the 1800's, now, with 350 million, it is another. It is as well, needless to say, unhealthy socially to have people of different ethnicities (hispanic especially) do all our work. I know this is not a political blog, but ...
Scott - you pointed out
"Shelter costs always lag the reality of housing prices by a considerable amount. Prices have been falling for almost a year, but shelter costs in the CPI have continued to rise. That will reverse very soon, and that will be the main impetus for a big drop in Core measures of inflation."
I would tend to agree if housing stock wasn't so out-of-balance. Housing stock has been grossly underproduced from 2008 (500k units) through 2021. We should have gotten back to producing 1.5m total units including MF in 2010 but we've been underproducing our needs since 2010 and at the same time the largest demographic group is just hitting their household formation peak over the next 3 years. We only hit the 1.5m unit mark again in 2022. I've been planning successfully and continue to believe the shelter-costs will continue to rise because of gross undersupply and heightened demand which won't soon be cured.
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QT should be accelerated, and the administered rates dropped. M2 might have dropped by $759 billion since October 2022, but large CDs have increased by $403 billion since then (and large CDs aren't included in M2).
In the commercial banking system, time deposits are just demand deposits that have shifted deposit classifications. That's how both fractional reserve and prudential reserve banking systems work. Banks are not intermediary financial institutions. Deposits are the result of lending, not the other way around.
In the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy
https://www.federalreserve.gov/monetarypolicy/files/20230616_mprfullreport.pdf
“The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates”
“Waller indicates that he is open to conducting QT while also cutting rates.”
That’s the prescription. Interest is the price of credit. The price of money is the reciprocal of the price level.
You drain reserves (like Bernanke did), and then gradually drive the banks out of the savings business (which doesn’t reduce the size of the payment’s system).
The five year breakeven is 2.14%. Why isn't this a more talked-about statistic?
Inflation expectations are not always correct. A dollar bill which turns over 5 times can do the same “work” as one five-dollar bill that turns over only once.
As fantastic as it sounds, economics is an exact science (like Irving Fisher said). But people like Jerome Powell don't get money and central banking. Powell thinks banks are intermediaries between savers and borrowers. Powell's peanut sized brain thinks in terms of an individual bank, as opposed to the commercial banking system as a whole (i.e., conceptually).
All time deposits are derived from demand deposits. As time deposits grow, demand deposits are depleted dollar for dollar. It's a closed system. All deposits are the result of lending, not the other way around.
And saver-holders never transfer their savings outside of the banks unless they are hoarding currency or convert it to another national currency, e.g., FDI.
"Liquidity Regulation" went the way of Regulation Q Ceilings.
Chat GPT: "The rationale for Regulation Q ceilings was to protect the profitability and stability of banks by reducing their cost of funding and discouraging excessive competition for deposits23. However, the regulation also had unintended consequences, such as creating a gap between market interest rates and deposit rates, encouraging disintermediation (the movement of funds from banks to other financial institutions that could offer higher returns), and stimulating the growth of money market funds and other alternatives to bank deposits."
That's the pervasive thinking. In reality, unknown to Chat GPT, the NBFIs are not in competition with the DFIs. The NBFIs are the DFI's customers. I.e., since 1933 disintermediation is a term that only applies to the nonbanks.
You can't trust machine learning. And you can't trust Powell.
Scott,
Any thoughts on what's going on with inflation in the UK?
O/N RRP volumes dipped below 2 trillion. MMMF rates, T-bills, are now higher than the award rate. That increases liquidity.
Unemployment data are about half or more of what the NBER and Fed use to monitor recessions. The initial and continuing claims are starting to look like they did in ~1999-2001 and ~2007-2009.
However, par for the course in this cycle, there is an unusual situation where continuing claims rose about a year and have since roughly plateaued. The initial claims continue to climb.
So one data set looks it is ready to improve or at least stopped deteriorating, and the other continues to get worse.
It still looks like the economy is slowing, barely.
https://fred.stlouisfed.org/graph/?g=16mdA
WorthF, re shelter costs. There may well be a shortage of housing these days, but there are contradicting realities. First, mortgage rates are very high. Coupled with housing prices that soared up to mid-2022, this has rendered housing extremely expensive. That’s why home sales are way down and there is scant inventory on the market (no one wants to sell, because they would lose their low-interest mortgage, and no one wants to buy because of high mortgage rates). Meanwhile, the construction of multi-family homes has soared to an all-time record. That means that over the next year there will be a tsunami of apartments and condos hitting the market as these homes are finished. if interest rates remain high and new supply hits the market, prices will have to decline. And they have been declining over the past 9 months or so. Rents are also declining. Simply put, the price of housing is too high given the fact that borrowing costs are also very high.
M2 down for the 2nd month in a row. M2 Is falling more than Biden.
https://www.reuters.com/markets/bis-warns-world-economy-critical-juncture-inflation-fight-2023-06-25/
No doubt you realize your opinion re inflation is in the minority of economists and I'm also sure you don't care! I take Powell at face value when he says there will likely be two more rates hikes before year end-whether we need them or not.
“Quantity leads and velocity follows” Cit. Dying of Money -By Jens O. Parsson
The overhang of fiscal and monetary stimulus is creating an historic drop in the demand for money (increase in velocity), as dis-savings proceeds.
Steve: with regards to taking Powell at face value, Silicon Valley Bank testified before Congress that they took Powell at face value back in the summer of 2021 when Powell told the banks that the 8.1% inflation was only "transitory" and that they wouldn't raise interest rates to any degreee until maybe 2023. SVB's CEO said that Fed's miscue helped to put them out of business.
B Gram, and Powell is absolutely determined to get inflation to 2%. 3-4% is in the cards but 2% may be somewhat more painful. Moreover the bond market is on the fence with the ten year at 3.7% or so. If the bond market was convinced the inflation fight was won and that our biggest risk was recession, rates would be lower. Of course the bond market could be wrong. Time will tell.
@steve:
The 10 Year TIPS/Treasury breakeven as at end-of-day June 23 2023 was 2.21%. That was in keeping with a headline PCE target of 2% over that period.
B. Gram: "SVB's CEO said that Fed's miscue helped to put them out of business. "
1. I have a relative who works for a tech co. that banked at SVB. A big part of the rumor was that they had a loan portfolio that was very bad- lots of vaporware/companies that would never be profitable--- in addition to mismanaging their investment portfolio.
2. Generally, bankers are not smarter than anybody else you meet. The whole system, including all of the big financial firms, basically bankrupted themselves in 2008... including people like Warren Buffet. Nobody is looking after my portfolio like that. I have to take action to avoid the downturns or suffer the losses. I try to avoid the losses.
https://www.mcclatchydc.com/news/nation-world/national/economy/article24532354.html
Another Banking Crisis Was Predictable - WSJ
"The original sin was monetary policy, Thomas Hoenig says, but regulators failed to heed the warning signs of a disaster in the making at SVB and elsewhere."
The government's deficits must be cut. Otherwise, term premiums are going to go up. Both higher interest rates & higher taxes erode the tax base increasing the volume of future deficits.
The O/N RRP facility volumes have now decreased by $441b, from $2,375b on 3/31/23 to $1961b on 6/26/23.
Contrary to the FED's GAAP accounting, this increases the supply of loan-funds necessary to cover the FED's issuance.
This is scary, because it shows deficits do matter.
And historically the Tips/treasury breakeven has been-utterly usage as an indicator of future inflation. Certainly didn't help last year!
Methinks that the incredible and unprecedented deficits the US is running along with private debt has something to do with stubbornly higher treasury bond yields. Scott has refuted this point but IF inflation is contained and IF recession is more of a concern we would not expect to see yields so high. As a bond trader in my fifteen year these are fascinating times.
Based on the May money #s, there will be no recession this year.
@steve:
I don't regard the US 10Yr. nominal yield or 10Yr. TIPS yield as "stubbornly high".
To my view it is the that the yields of the QE era (I'll say inception 2008 through institution of quantitative tightening in 2022) were stubbornly low!
Forming expectations from the last 15 years may be misleading if that change in regime is material. The 10Yr. nominal yield and the 10Yr. breakeven yield are in keeping with pre-2008 yields.
Scott - I watch the inventory of Multi-family and single-family closing and you aren't arguing from the numbers.
You say..."Meanwhile, the construction of multi-family homes has soared to an all-time record. That means that over the next year there will be a tsunami of apartments and condos hitting the market as these homes are finished. if interest rates remain high and new supply hits the market, prices will have to decline."
I could care less whether multi-family has soared to record all-time record, it's total multi-family and single-family which matters. we still won't come close to all-time record highs in both and because of interest rates, it just means more people will move into multi-family than into their OWN home. The supply of total units just isn't there to push down home-prices and rents on multi-family, etc..much overall.
There is a lack of supply and the demand is increasing, period. The lack of supply isn't and hasn't met demand since 2007 in the country. Of course, every market is different and in some places prices will come down but that is always the case in individual markets like it's been in greater-Detroit since the late 80's.
interest rates means less money chasing these leveraged (mortgage) assets but the supply is way behind demographically and we are FAR from oversupply on a national basis, so that part of your equation and argument is not based on the numbers.
https://www.ftportfolios.com/Blogs/EconBlog/2022/4/11/housing-heartburn,-not-a-heart-attack
Also from Wesbury (April 2021) and others....
"The primary problem is a lack of homes. Based on population growth and scrappage (voluntary knockdowns, fires, floods, hurricanes, tornadoes...etc.), we would normally expect housing starts of 1.5 million per year. But in the past twenty years (March 2001 through February 2021), builders have only started 1.256 million per year. Builders haven't started more than 1.5 million homes in a calendar year since 2006."
The 2 year note futures today, despite the tenor of Powell's comments, are trading up on the day.Now even the short end of the yield curve is ignoring his commentary.
I appreciate the informative blog on how inflation is under control. It's reassuring to see the economy maintaining stability. This news feels like a "link scooter" to a smoother financial journey ahead.
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