Tuesday, February 13, 2024

The CPI overshoot is a statistical artifact

The January CPI overshot expectations by 0.1% and the stock market had convulsions. It's absurd. 

If it weren't for shelter costs, which now comprise 25% of the CPI, the year over year change in the CPI would have been 1.6%, well below the Fed's target and very good news for everyone. But the way the BLS calculates shelter costs has boosted the reported year over year change in the CPI to 3.1%. Over the next 9 months, it is highly likely that shelter costs will fall by more than half, thus subtracting significantly from reported CPI. Meanwhile, the ex-shelter version of the CPI has been very well-behaved. 

This is all a statistical tempest in a teapot. 

Chart #1

Chart #1 shows the reported change in the CPI (blue line, 3.1%) and what it would have been ex shelter costs (red line, 1.6%).

Chart #2

Chart #2 shows us that the Fed's method for calculating shelter costs today (the majority of which comes from Owner's Equivalent Rent) has a very high correlation with the change in housing prices 18 months ago. Absent any change in this methodology, we can predict that the change in OER will fall from the current 6.2% to 2.8% over the next 9 months. Thus, future declines in OER, which are virtually baked in the cake, will subtract over half of the difference between the headline CPI and the ex-shelter CPI between now and September '24. 

Chart #3

Chart #3 shows the level of the Consumer Price Index ex-shelter costs. Note the rapid growth from mid-2020 to mid-2022, when the index rose over 23% (which translates into an annualized rise in prices of over 11.9%). Now note how the growth of the CPI ex-shelter slowed dramatically beginning in mid-2022. Since June 2022, the Consumer Price Index has increased at a benign rate of 1.2% per annum, and as noted above, it has increased 1.6% in the past 12 months with no signs of any acceleration. Once again, it is safe to conclude that shelter costs and the way they are calculated have clearly overstated inflation. 

The Fed will figure this out sooner or later. Meanwhile, short-term interest rates will be higher than they need to be, but not forever. Monetary policy is "restrictive" only in the sense that borrowing is more expensive than it needs to be. But because bank reserves are super-abundant (see Chart #2 in my last post), liquidity is abundant and the economy can continue to grow as it has in the past year or so—despite higher-than-necessary interest rates. 


Joe Palmer said...

Supercore, excluding housing, up .83% MoM in today's report. 10Y treasury broke higher out of its recent range to 4.3%. Many valuation models would have the SP500 1000 points lower at current yields and earnings.

Vandy said...

And those models (ala Brian Wesbury’s Capitalized Profits model)have been spectacularly wrong in guiding investors what do do over the past few years.

Steve said...

Permabears have been doomcasting the SP500 for the last decade. Is the Shiller PE ratio no longer valid?

Grechster said...

In a previous post, you showed a chart that compared the real Fed Funds versus the 5-year TIPS. My interpretation of that chart is that the Fed is officially too tight right now. And judging from past episodes when the real Fed Funds were too tight, the market is on borrowed time - a time span that could last up to 18 months. This archaic way of looking at housing costs would seem to be the reason that the Fed feels justified in being too tight.

Despite this "too-tightness" liquidity seems plentiful.

So what do you make of this dynamic? Is the Fed too tight? If so, do you think it will result in a market crack-up a la 2008 or 2000? Or is this time somehow different given the still-plentiful liquidity?

Mark said...

Scott, I continue to have problems processing the bank reserve/liquidity aspects of your no-recession-is-therefore-imminent argument (my problem ... not a criticism). Let's say real rates were not just "somewhat" higher than they currently need be, but let's say they were substantially or dramatically higher. Would that impact the likelihood of recession? And if so, would that be seen first through diminished liquidity, or could it skip that step?
Thank you.

Scott Grannis said...

Re "is the Fed too tight?" The spread between 5-yr Treasury yields and 5-yr TIPS real yields has risen from a low of 2.06% in December to now 2.38%. This strongly suggests that the market thinks that monetary policy has become easier (because inflation is now expected to be higher over the next 5 years). On the other hand, the real yield on TIPS has risen from a low of 1.6% at the end of January to now 1.9%. That suggests that monetary policy has tightened (the real yield being the best measure of how tight policy is). The combination of the two suggests that while policy has tightened, it hasn't tightened by enough to really bring inflation down. That explains why the market has pushed out its forecast of Fed ease: it will take some time for the current tightening to take effect.

wkevinw said...

CPIOER lags Case-Shiller rate of change peaks and troughs by 12-15 months. Case Shiller peaked in ~March or 2023, so CPIOER should still have a few months of being sticky.

It's one of the several problems the Fed deals with and/or uses to their "advantage". Powell is hiding behind these lags at the moment to argue for watching the data.

I hope the Fed goes toward price discovery/free markets.

wkevinw said...

I just looked at the Case-Shiller chart. There is another peak in the rate of change a ~6 months after the one in early 2023. (Yet another dysfunction in the economy caused by all this government manipulation of the financial system.)

So, Owners Equivalent Rent might be very sticky for many months- not at a very high level, but it might not decrease as much as one would like.

Steve J. said...

housing prices have not come down in New England

Benjamin Cole said...

Housing (should be) the biggest issue of 2024, but instead everyone is jibber-jabbering about ID politics and Hamas.

Housing costs are doing the California thing, across the US.

The obvious solution is total decontrol of property zoning, and go to free markets.

But...there are no libertarians, and no liberals either, when neighborhood property zoning is under review.

Not sure there is a fix. Consign your kids and grandkids to permanently higher housing costs, and lower living standards. And buy residential property, if you can swing it.

But not in a kook-state like California.

DanQ said...

Excellent analysis as usual, Scott. The Fed's high rates are hindering the creation of new housing supply. You can see the impacts very clearly in the housing starts. New housing supply is needed to meet the demand for housing. Nationally, we are probably at least 2 million units short of where demand is. Where is the CPI the highest? OER/shelter/housing. The Fed needs to get out of the way.

David Landy said...

Scott, curious if you think this (increase in monetary base) is significant? It seems to contradict some charts you've shown recently of M2 and currency in circulation, which are both going down.


wkevinw said...

Market manipulation causing distress in the Real Estate market. Financialization from central bank (prior to fed hikes) keeping rates too low and other forces keeping income inequality too high. The rich elites, especially in government, don't care (and may think this is the desirable state of this market- don't own anything and be happy).


Salmo Trutta said...

The pervasive error in economics is that banks lend deposits. No, loans = deposits. An increase in DDs depletes TDs by an equivalent amount. Thus, the change in the composition of the money stock propels N-gDp. That, and short-term and long-term money flows (our means-of-payment money), reversed in Dec.

Salmo Trutta said...

"The Fed has to watch how take-up at the O/N RRP facility will evolve, as a quick shift into (out of) the facility could drain (boost) reserve balances."


Retail money market funds are double counted in the money stock.

But Grannis is still right. Long-term money flows are likely to fall below zero for the first time in the last half of 2024. Note that the duration and magnitude of other money supply metrics is contrary to the evidence:

Irving Fisher (1925) was the first to use and discuss the concept of a distributed lag.
See also: “The Lag from Monetary Policy Actions to Inflation: Friedman Revisited” 2002

Salmo Trutta said...

Loans = Deposits. An increase in one deposit classification depletes another classification dollar for dollar. All monetary savings originate within the payment’s system. DDs are just shifted into TDs. And banks don’t lend deposits. All monetary savings are lost to both consumption and investment.

The composition of the money stock has changed. That’s a “sea change”. AD will be higher as a result, and so will interest rates.

Scott Grannis said...

David Landy, re monetary base: The monetary base today is fundamentally different from what it used to be prior to 2008. The base = bank reserves + currency in circulation. Since 2008 reserves have become abundant, whereas they were always scarce prior. I don't see the base today providing any insights into inflation.

The Coral Gardner said...

Reading today's WSJ I came across a story pointing out that overnight reverse repo market has fallen from $2.5 trillion to $0.5 trillion. The article goes on to speculate that this trend may presage higher rates as more government debt is pushed to longer bonds. Do you think this topic is one you might cover in a future post. Avid reader in NY. JP

Salmo Trutta said...

“I know of no model that shows a transmission from bank reserves to inflation” – DONALD KOHN – former Vice Chairman of the Board of Governors of the Federal Reserve System

“Reserves don’t even factor into my model, that’s not what causes inflation and not how the Fed stimulates the economy. It’s a side effect.” – LAURENCE MEYER – a Federal Reserve System governor from June 1996 to January 2002

Pre-2008, legal reserves were costless and showered on the system. They were the basis for monetarism. With the payment of interest on interbank demand deposits, there is little reserve velocity.

The volume of money (stock) is irrelevant unless it is turning over (flow).

Salmo Trutta said...

Lags are constants. Powell is doing an exceptional job holding the money stock constant. We’ll see a drop in rates in the last half of 2024.


wkevinw said...

Federal Reserve- illegal activities?

There have been several academic papers written about the activities of the Fed since 2008.

I don't pretend to understand everything they do now. For example, it seems like they are now "allowed" to buy just about any security- US Govt bonds, MBS (are these private company instruments now?), State Govt bonds. As such, just about any destructive behavior can be bailed out by the Fed.

I guess MBS still get traded and there are credit default swap instrument traded on these. However, I think all(?) mortgages are essentially backed by the US Govt now. So, I don't understand who is responsible for payment.

I think most of this Fed activity should be stopped. Probably the US Congress is the only place that this could happen.