Wednesday, November 15, 2023

Inflation RIP

I've been predicting the demise of inflation for at least a year now, and today's CPI report makes it official—there's no denying that inflation has fallen to within spitting distance of the Fed's target. Not coincidentally, the market has finally acknowledged what I've been expecting for many months: the chances of another Fed tightening at this point are zero. The only issue now is when the Fed starts to cut rates; the market thinks the first cut comes at the May 1st FOMC meeting, while I think it happens much earlier.

Chart #1

Chart #1 compares the year over year change in the CPI to the CPI minus its shelter component (which comprises about one-third of the CPI index). Absent shelter costs, which we know have been artificially inflated due to the BLS's flawed methodology (see Charts #2 and #3), the CPI is up only 1.5% in the year ending October '23. In fact, by this measure, inflation has been at or under the Fed's target for the past six months.

Chart #2

Chart #2 shows the 1- and 3-mo. annualized rate of change in Owner's Equivalent Rent (the major component of shelter costs). Here we see that shelter costs have been rising at a 5-6% annualized rate for the past several months. Contrast this to the fact that nationwide housing prices, according to the Case-Shiller index, have only increased 1.4% since mid-2022. Bottom line, the OER is substantially overstating inflation.

Chart #3

Chart #3 is designed to show that the BLS methodology effectively uses changes in housing prices from 18 months prior to drive changes in Owner's Equivalent Rent. Big changes in housing prices thus feed into the CPI calculation with a lag of as much as 18 months! This chart also strongly suggests that the big deceleration in housing prices that began a year ago last summer will cause the change in OER to fall to close to zero over the next 9-10 months. That in turn strongly implies that the contribution to inflation that comes from shelter costs will be declining for many months to come. It wouldn't be surprising, therefore, to see overall CPI inflation fall into negative territory in the next 3-6 months.

Chart #4

Chart #4 shows that changes in the growth rate of the M2 money supply tend to show up in similar changes in the rate of inflation with about a 1-year lag. This is strong evidence that the recent bout of inflation we have endured had a monetary origin. As I've explained numerous times in the past year or two, the source of our inflation surge can be traced to the monetization of some $6 trillion in federal deficit spending in 2020-2021. Happily, there has been no further debt monetization since 2021.

Chart #5

Chart #5 shows the 6-mo. annualized rate of change of overall and core producer prices (producer prices tend to be upstream of consumer prices, so this is like seeing a preview of the trend of the CPI in the months to come). By this measure, inflation is running at a 0-2% rate. Moreover, the producer price index has not changed at all since June '22

Inflation is dead, may it Rest In Peace.

Is there any reason at all for the Fed to hold off on lowering rates until May? Not that I can see.

Monetary policy is manifestly tight, as reflected in a variety of indicators: 1) a significant deceleration in the rate of nearly all price increases, 2) a 57% plunge in new mortgage originations since early 2022 (i.e., high interest rates have severely impacted the housing market), 3) a 20% decline in non-energy commodity prices since early 2022, 4) at 2.3%, real yields on 5-yr TIPS (an excellent barometer of how tight monetary policy is) are substantially higher than their 28-yr average (1%), and 5) the yield curve is still inverted.

If the Fed remains true to form, they will wait too long to lower rates, just as they waited too long to raise rates two years ago. And that, in turn, means that when they eventually do lower rates, they will have to lower them faster and by more than if they were to start now.

The good news is that there is still little or no reason to think that the economy is at risk. Swap and credit spreads are low, implied volatility is low, initial jobless claims are low, and liquidity is abundant. 

UPDATE (11/16/23): Here is an updated bonus chart showing how the federal deficit was monetized in 2020 and 2021, and how that link was severed about a year ago. Today we have big and ongoing deficits measured in trillions of dollars, but they are no longer translating into big increases in the money supply. This is how it should be. Deficits should never be monetized, and as such they needn't be inflationary. But since today's deficits are the by-product of excessive spending, they represent a drag on growth. The government is borrowing money and spending it wastefully. That squanders scarce resources and depresses the economy's long-term growth potential. Our children and grandchildren will pay the price in the form of living standards that could have been higher. 

Chart #6


Larry said...
This comment has been removed by the author.
Tony O. said...


What are your observations regarding the National Debt, and a potential monetization of that debt?


Tony Orfanos

Stardust Capital said...

great job Scott!!

The Commodity Guy said...

Take a bow Mr. Grannis. I hope you traded it successfully. I did.

Holsinger said...

My view is the Fed is not seeking a 50/50 path ahead. They want a 90/10 probability against relaxing too early and then having to retighten. That would be embarrassing.

K T Cat said...

I've been pretty sanguine about my portfolio over the last few years because I read your blog. Thanks for the peace of mind. I'm an older fellow and I've just let it all ride because I'm not quite at the point where I need it yet. It's been a lot less stress to leave things be than try and time the market, which, as I have learned in the past, is a fool's errand.

Thanks again, my friend. God bless you and yours.

Salmo Trutta said...

Kudos for staying the course. My favorite graph is "M2 Growth vs. the Federal Budget Deficit"

DanQ said...

Great analysis Scott. It's good to see prominent publications like the NY Times blasting the Fed for ruining the housing market with its punitive mortgage rates and the negative supply shock they are causing to housing production. The country has dramatically under-produced the amount of necessary housing since the aftermath of the 2008 financial crisis. It might be 2 million units or so. Jerome Powell and the Fed should probably make some comments about this. The cure for high housing prices is expansion of supply combined with reasonable interest rates.

Unknown said...

Assuming the Fed's current interest rate policy is too restrictive, what is the possibility we'll see a recession in 2024?

Scott Grannis said...

Fed policy is clearly tight, but so far the only sector that is really struggling as a result is housing. Today's Housing Market Index of builder sentiment was very weak, falling to 34 (normal would be 70-80). New mortgage applications are way down also. Housing desperately needs lower interest rates and/or lower prices. I would note however that 30-yr fixed rates for mortgages are definitely declining and should continue to do so, even though they remain still quite high. More relief is needed and it should arrive; a Fed ease would accelerate the process.

As for a recession next year, it's certainly not imminent. Housing is in bad shape, but the rest of the economy continues to muddle along. No boom, no bust continues to be the mantra.

steve said...

Well called. You were early and largely lonely. Take a bow.

Henry H said...

Do you expect the inverted yield curve to normalize next year?

Scott Grannis said...

"Do you expect the inverted yield curve to normalize next year?"

Downtown Adam Brown said...

@Scott Grannis "As for a recession next year, it's certainly not imminent. Housing is in bad shape, but the rest of the economy continues to muddle along. No boom, no bust continues to be the mantra."

I guess you could call that a soft...coasting?

cyclingscholar said...

Well done Scott. I hope you experience a surge in readership looking for intelligent analysis instead of inflation-will-kill-Amerikkka gibberish widespread on financial websites that should know better.

Mano Appapillai said...

Does the budget matter ? Can you please comment SKelton view:

The leading thinker and most visible public advocate of modern monetary theory -- the freshest and most important idea about economics in decades -- delivers a radically different, bold, new understanding for how to build a just and prosperous society.
Stephanie Kelton's brilliant exploration of modern monetary theory (MMT) dramatically changes our understanding of how we can best deal with crucial issues ranging from poverty and inequality to creating jobs, expanding health care coverage, climate change, and building resilient infrastructure. Any ambitious proposal, however, inevitably runs into the buzz saw of how to find the money to pay for it, rooted in myths about deficits that are hobbling us as a country.
Kelton busts through the myths that prevent us from taking action: that the federal government should budget like a household, that deficits will harm the next generation, crowd out private investment, and undermine long-term growth, and that entitlements are propelling us toward a grave fiscal crisis.
MMT, as Kelton shows, shifts the terrain from narrow budgetary questions to one of broader economic and social benefits. With its important new ways of understanding money, taxes, and the critical role of deficit spending, MMT redefines how to responsibly use our resources so that we can maximize our potential as a society. MMT gives us the power to imagine a new politics and a new economy and move from a narrative of scarcity to one of opportunity.

Richard H. said...

I guess one swallow makes a summer on this blog.
All inflation is theft. The productivity increases of the last century should translate into deflation, of course. The excuse against deflation is the ridiculous concept that you will
delay your purchases for a year - utter nonsense, just like the magical number of 2% inflation being a good thing - nonsense.
Scott could be right that we may go down to 2% inflation. But this is still a crime. However, I still think that the cat is out of the bag, that because of changing consumer habits - the pandemic finally put an end to the post 2008 inhibition on spending - the world situation, and the spending that will bring about, the domestic spending, all this will have to be monetized by the Fed.

Salmo Trutta said...

re: "all this will have to be monetized by the Fed."

Yes, as soon as the O/N RRP facility dries up. Draining the O/N RRP facility is just like monetizing the fiscal deficits. MMMFs aren't banks, they're nonbanks. So, the draining is not a liability swap.

alpacino said...

Hi Scott,

Do you analyze the Canadian economy at all? We had a huge boom in housing the last 10 years. Wondering if you think a bust is comin there? TY

Scott Grannis said...

Re Modern Monetary Theory: MMT is modern-day snake oil. It rests on the belief that government can spend money more productively than people can themselves, and it also assumes that government deficits can be funded virtually without limit by printing money. I note that Skelton comes from the far-left fringes of economics, and her policy positions, not surprisingly, support the far-left's penchant for massive and ongoing government spending to correct all sorts of economic and societal ills. I know of no country that has ever prospered under a regime of massive government spending. Argentina is perhaps the classic example of this, and the results have been catastrophic.

Scott Grannis said...

alpacino: I don't follow Canada. But I know that in the US, housing booms are typically followed by busts.

Roy said...

Milei won! Fascinating times.

Matt from Cleveland said...

Good news on inflation. The down side is it may promote Biden’s re-election by taking economic malaise off the table. For sure the corporate media will trumpet it and all the low information voters will fall into line.
Matt in Cleveland