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Shelter costs comprise about one-third of the CPI, and shelter costs are driven primarily by housing prices 18 months before. Which is to say that the way BLS goes about calculating the CPI is bogus. If we take out this bogus component of the CPI we are left with the fact that the CPI rose a mere 1.4% in the 12 months ended November '23. Long story short: the Fed has successfully stomped out the inflation fires that started back in early 2021. The inflation that is still grabbing headlines today is an artifact of the crazy way that the government has decided to measure shelter costs.
Of course, shelter costs are not the source of inflation—they are the result of inflation. Since June 2022, readers of this blog have known inflation was going to decline. That was when I confirmed the impressive decline in the M2 money supply. As I explained at the time, huge growth in M2 from 2020 to 2021, fueled by the monetization of Covid-related deficit spending, was the proximate cause of our national inflation nightmare. M2 continues to decline, and interest rates continue to be high (both of which mean monetary policy is tight), so shelter costs and the broader CPI will likely continue to decline as well.
Chart #1
As Chart #1 shows, the Owner's Equivalent Rent component of the CPI (red line) is primarily driven by changes in housing prices (blue line) with a lag of about 18 months. If this correlation continues (as is quite likely), then the contribution of OER to the CPI will be declining for another 12 months or so.
Chart #2
Chart #2 compares the year over year change in the CPI with a version of the CPI less shelter. Amazing fact: the 6-mo. annualized rate of change of the CPI less shelter has been 2% or less for 11 of the past 12 months!
Chart #3
Chart #3 compares the value of the dollar (inverted, blue line) to the level of non-energy commodity prices. Normally, there is a strong inverse correlation between the value of the dollar and commodity prices. The strengthening of the dollar in recent years (shown here as a declining blue line) has exerted a strong deflationary influence on commodity prices, just as has happened during prior episodes of a stronger dollar (e.g., from 2011 through 2015). In inflation-adjusted terms, commodity prices have fallen by about 25% since March '22, which was just a few months before the CPI peaked in June '22. This lends further weight to the idea that inflation is continuing to decline. (Commodity prices usually react early to changes in monetary policy.)
If these trends continue to play out, don't be surprised when you see negative consumer price inflation within the next 6 months. And don't be surprised if the Fed figures this out and lowers interest rates well before, and by more, than the market currently expects.
21 comments:
Thank you, Scott.
An interesting chart:
https://twitter.com/fkronawitter1/status/1734905029541146886/photo/1
"Supply chains are getting tighter again, historically they have lead CPI by ~5 months"
I get where you're coming from on OER, but let me re-ask a question I accidentally flubbed in a previous post.
"If the Fed *lowers* rates before mid-2024, housing prices will accelerate higher"
I just wonder whether the Fed wants housing prices to re-accelerate next year. Someone correct me if they think I'm wrong, but it seems to me that holding rates elevated until well after buying season starts might allow the Fed to cut rates, while avoiding at least some of the eventual increased inflation that home-price rises will bring.
Scott,
You said "huge growth in M2 from 2020 to 2021, fueled by the monetization of Covid-related deficit spending, was the proximate cause of our national inflation nightmare."
What is do you mean when you say "monetization of Covid-related deficit spending?"
i.e. What is "monetization?"
Thanks.
My favorite price/inflation indicator is ppi. It tends to lead cpi by 6-12 months, but can be less leading/coincident sometimes. It looks like the cpi will likely be declining for about another 6 months.
The Fed has a 2-3 issues (as they always do, economics being the great social science of "consequences"/"tradeoffs").
The Fed has to be careful about housing/rent costs, timing of rate changes (cuts) during a presidential election year, and unmanageable federal government debt service.
The RE market is still very dysfunctional. How that gets "normalized" will be part of the story on this whole episode.
Yeah, we have Karl Marx's rentier capitalism (exorbitant home prices). Bernanke's "wealth effect" has been denigrated.
Asset valuation prices are driven from the appraisal of loan collateral, in this case Reserve Bank credit, which depends upon Gresham’s law: "a statement of the least cost “principle of substitution” as applied to money: that a commodity (or service) will be devoted to those uses which are the most profitable (most widely viewed as promising), that a statement of the principle of substitution: "the bad money drives out good".
Bernanke held the means-of-payment money constant for 48 months causing the GFC. Powell has held it stable for 20 months, with rents still climbing.
Scott,
So, how equity may react if your scenario plays out?
Adam, re how would equities react to lower-than-expected rates: I think the answer to your question is basic math. In principle, equity prices discount future earnings by some interest rate. If that rate falls, then equity prices should rise. Common sense suggests the same, since an easier-than-expected Fed monetary policy reduces the chances of recession, and that in turn increases projected earnings.
Re "what is monetization?" In a normal world, Treasury must finance deficit spending by selling notes and bonds to the public in exchange for money, and that money is then spent by Treasury. When this happens, no new money is created—it simply changes hands, from the public to the Treasury. What happened in 2020-21 appeared to violate this, because $6 trillion of deficit spending was matched almost dollar-for-dollar by a $6 trillion increase in the M2 money supply and $6 trillion of note and bond sales. Thus it appeared that banks had effectively bought $6 trillion of notes and bonds by "creating" (only banks can create money) $6 trillion of new money. I say "appeared" because I can't pin down exactly how this happen, only the result of what happened, and I don't know of anyone who has yet discovered how it all happened. This money creation is otherwise known as the monetization of Treasury's deficit spending.
Re: what would happen if the Fed lowers rates sooner than expected: It's tempting to think that lower mortgage rates would cause housing prices to rise, since lower rates would reduce the cost of financing a home purchase. But this ignores the impact that lower mortgage rates would have on homeowner's willingness to offer their home for sale. Currently, the great majority of homeowners have 3% mortgages and are keeping their homes off the market because if they sell they would have to then buy another home with a much higher mortgage rate. Thus, lower mortgage rates would probably result in an increase in the supply of homes for sale.
So, lower rates would make it easier to buy a home, while also increasing the number of homes for sale. The impact these two variables might have on home prices is difficult to predict. My guess is that prices would tend to fall as mortgage rates fall.
As I write this, the FOMC meeting has just concluded and the market has interpreted the Fed's remarks to mean that the Fed is now more willing to lower rates next year than previously thought. As a result, equity prices have surged and interest rates have plunged. Good news!
Scott,
A BIG thank you for helping us through the inflationary and monetary issues of the last few years. You have been so right and today’s Fed report in essence is the culmination of your predictions. But that is nothing new as you have been sharing your insights since the beginning of the GFC in 2008 and been so helpful to so many of us who follow your
Blog religiously.
Wishing you and your family happy holidays and a healthy new year!
Kenneth
Scott,
Following up on “monetization”: Is it fair to say that the $6 trillion increase in the money supply that you refer to was not matched by either a corresponding increase in a) debt sold to the public OR b) debt created and held by the FED? Is there a mismatch when both of these modes are considered?
Kirk
Scott- your honest commentary is so valuable.
1. Yes- appears the Fed is willing to cut. Whether early or late 2024 is the question
2. RE Market- if more supply accompanies lower rates, then that market can normalize. Hadn't previously considered that path
3. Mystery of government spending monetization. I also don't understand.
Thanks as always
Scott, as a long time reader of your posts I also would like to express my gratitude for your work.
Being in Australia where mortgages are variable rate or relatively short term fixed rate I wonder though would not the increase in the supply of houses to the market (by those currently keen to retain their low interest rate mortgages) resulting from the decrease in interest rates be matched by the increase on the demand side as these sellers will seek to purchase a replacement home to live in? In that case and all else being equal the decrease in interest rates will be a firm positive for residential real estate. Thanks again.
Love the update.
I quibble with the housing costs explanation.
Supply has been suffocated by local government stipulations.
There are no libertarians, and no liberals, when neighborhood property zoning is under review.
Scott, you write: Re "what is monetization?" In a normal world, Treasury must finance deficit spending by selling notes and bonds to the public in exchange for money, and that money is then spent by Treasury. When this happens, no new money is created—it simply changes hands, from the public to the Treasury. What happened in 2020-21 appeared to violate this, because $6 trillion of deficit spending was matched almost dollar-for-dollar by a $6 trillion increase in the M2 money supply and $6 trillion of note and bond sales. Thus it appeared that banks had effectively bought $6 trillion of notes and bonds by "creating" (only banks can create money) $6 trillion of new money. I say "appeared" because I can't pin down exactly how this happen, only the result of what happened, and I don't know of anyone who has yet discovered how it all happened. This money creation is otherwise known as the monetization of Treasury's deficit spending.
First, thanks for your efforts over the years, like another commenter on this thread, I too have been learning from you since 2009 (when "everyone" said there would be massive inflation from QE...and there never was...I went searching for an explanation of how everyone got it so wrong. I finally found your blog. For others wanting an understanding of that era, I believe Scott's posts from that time are still up. If you print them all out, they are worth far more than their weight in gold [the gold everyone was saying to buy because of the forthcoming massive inflation that never materialized]).
Back to my question -- this response of yours addresses my main remaining question from the recent bout of inflation. It is clear that you're not sure -- yet -- what the answer is but might it come? How can we know -- in real time -- whether our gov't is monetizing? Or, how come we cannot, as it were.
How is 1.4% success? Under Biden the cost of the necessities of life is up at least 25% so far. We need at least a 10 to 15% deflation over the next year to achieve 2% per year over the Biden years. This will not happen as we all know. People on COLAed transfer payments, fixed incomes and the bottom half of the labor force have seen a drastic reduction in living standards. Retirement portfolios are down when discounted by the 25% inflation.
Economic statistics tell a different story. They have become totally disconnected from reality.
What economic themes do you expect to materialize in 2024, not necessarily what dominates the media cycle.
2024 Themes:
1. Elections, immigration and global conflicts dominate the news cycles.
2. Morgage rates fall to 5.0-5.5%, and existing housing sales revert to the mean.
3. Commerical Real Estate sales revert to the mean (off 80% in 2023). Except office.
4. Fed cuts rates to 3.25% by YE, the 10-year stays in the 3.5-4.0% range in 2024.
5. S&P 500 hits a record high 4,800 and then trades sidesways for all of 2024.
6. AI continues to advance rapidly and transforms programing. ChatGPT 5.0 arrives.
7. Job growth and consumer spending stalls in 2024 because the Fed's delayed rate cuts.
8. A base is built in 2024 which sets the stage for a 5-year bull run led by US productivity gains.
9. South American growth takes off as Argentian leads the way with transformational reforms.
Hello,
My five cents. As Scott expects negative CPi print, that could lead to a change in rates expectations. Now mkt expects ca 3.5% as a new equlibrium. If that moves lower, than we again might have growth stocks rally.
Interesting economic performance for about the past 3 years.
GDP is up about 3% per year, which is relatively good. So, the financial markets and investors (relatively wealthy) are feeling pretty good.
Average weekly earnings are down about -0.7% per year, which is not good. So, average joe and jane are not that happy. It's a bit worse than this because it's an average/mean- median in this set of data is even a worse performance.
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