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I've only recently returned from several weeks in Argentina. I didn't have access to my charts, and besides, I was rather more interested in people, food, and wine than in blogging. Time now to catch up on the market's latest focus: Is inflation still stubbornly high? Does the Fed need to tighten more?
The March CPI release was, in retrospect, the one that apparently convinced the Fed and the market that "disinflation has stalled." More recently, the market, with encouragement from numerous Fed governors, has come around to thinking that instead of cutting rates five times by the end of this year, we might see, at best, one cut, because the Fed has more work to do. "Higher for longer" is now the interest rate mantra that is driving the market; it's made people nervous, so an equity market correction is underway.
You won't be surprised to learn that I disagree. I still think the great inflation bubble that started three years ago has long since popped. And the main reason inflation is still marginally higher than where the Fed would like to see it is the way shelter costs are calculated. I think the following charts make that clear.
You won't be surprised to learn that I disagree. I still think the great inflation bubble that started three years ago has long since popped. And the main reason inflation is still marginally higher than where the Fed would like to see it is the way shelter costs are calculated. I think the following charts make that clear.
Chart #1
Chart #1 compares overall inflation to inflation less its shelter component, which is about one-third of the total. Both are calculated on a 6-mo. annualized basis, which is the best way to see if recent developments mark a change in the broader trend. My first take when looking at this chart is that if there is an inflation problem in today's numbers, it pales in comparison to the numbers we saw in the 2005-2009 period.
Looking closer, I note that the 6-mo. annualized rate of inflation less shelter has averaged 1.6% for the past 16 months, and it has been more than 2.0% in only four of those months. Moreover, there is no sign of any meaningful recent acceleration: it has averaged only 2.01% over the past 4 months and it was 2.06% in March '24. As for the overall CPI, it has averaged 3.3% over the past 16 months, and it was 3.3% in March '24. The difference between the two is due entirely to shelter costs, which, arguably, have been artificially inflated by the way BLS calculates them.
Chart #2
Chart #2 shows that the year over year increase in shelter costs as calculated by the BLS is driven almost entirely by the year over year change in nationwide housing prices 18 months prior. (The red line has been shifted to the left by 18 months, and the two lines match up almost exactly.) Even though housing price inflation has dropped significantly from its peak two years ago, and nationwide rents have been flat to down over the past year, the BLS calculates that shelter costs currently are rising at the rate of 5.9% per year. If the relationships in this chart hold, then the rise in shelter costs will reach a low point this coming October (which is the point where the blue line falls to zero). In other words, shelter costs will almost certainly continue to decline every month from now until October, and that will subtract significantly from the increase in the overall CPI.
Inflation is not a problem. The Fed once again is late to the party, as usual. If the Fed keeps short-term interest rates higher for longer it will only push inflation lower, and there's nothing necessarily bad about that. In any event, I'm willing to bet that interest rates don't remain at current levels for as long as the market is currently forecasting. At some point the Fed is going to figure out that it's done enough.
22 comments:
This seems like a simple and obvious analysis. What incentive does the Fed have to ignore it? It's hard for me to imagine that they are lacking any understanding of how this works, so what then is the disconnect? What else is at play here other than your prudent and easy to understand calculation?
Any thoughts on the car insurance component moving higher? I haven’t read any compelling arguments. Is this short term noise? Thanks.
Why is the Fed ignoring the points I’ve made? Several hypotheses:
1) Optical risk: the latest CPI prints exceeded market expectations, albeit only modestly. The press made a big deal of it. The Fed cannot ignore what the press and the market are focused on.
2) Once burned twice shy: The Fed made a huge mistake ignoring completely the surge in M2 in 2020 and the early signs of rising inflation in early 2021, insisting that rising inflation was only “transitory.” They dare not make another similar mistake. Better to err on the side of caution.
3) The economy has not weakened: Although the Phillips Curve theory of inflation has been serially debunked, it still lives on in the minds of the unenlightened. Phillips Curve theory says the economy must weaken—as a result of tight monetary policy—before inflation can really decline. Instead, the economy surprised nearly everyone on the upside last year. Too many people at the Fed worry that strong growth is inflationary. The press firmly believes this as well.
Ai, re auto insurance: Inflation is not caused by rising prices. It’s caused by an imbalance between the supply and demand for money. If money supply and demand are in balance, the overall price level will not rise, but that doesn’t mean that some or even many prices may continue to rise in various sectors of the economy. Think of money supply and demand in balance as equivalent to living on a fixed budget: if the price of one thing in your basket rises, you are forced to spend less on something else. Rising prices for energy, for example, essentially force falling prices for non energy items. Similarly, rising wages do not cause inflation if money supply and demand are in balance. Rising wages in that case simply reflect increasing productivity; more is being produced by a giving amount of labor, therefore labor becomes more valuable/expensive.
Correction: in the above, “many prices may continue to rise” should instead read “many prices can’t continue to rise”
Thank you, very helpful.
Do you buy any of the open border issues impacting jobs, in turn impacting the Phillip Curve rationale of needing to see less workers employed states by the Fed?
Belated but appreciated.
Hi Scott. I think you are looking a little bit in the review mirror as far as reported CPI/PPI. The CRB index is telling us something different - maybe that fiscal policies will be monetized. Gold of course too, but that can be attributed to political/war concerns. Or maybe that is just it; war equals spending money we don’t have.
It would be nice if the Fed just facilitated money demand, as you said, but the Fed never reels back in money when people don’t want it - it is too politically difficult. Money demand comes and goes, supply is forever.
As you have said many times, M2 growth has averaged 6% for years/decades. This is not sustainable without inflation when we have only 2% GDP growth. Just because we got lucky that prices and interest rates remained low after the great recession, does not mean that this is normal. We know the reason for this - banks were not loaning money.
As I have said before here, the norm should be deflation. That is the payoff from productivity growth. We continue to be cheated by our government with the notion that 2% inflation is the right amount. Deflation that is the same rate as productivity growth is what we want.
Contrary to the FED, MMMFs are nonbanks. And retail MMMFs are not bank liabilities. So, money drained from the O/N RRP increase both reserves and the money stock. The FED has shot itself in the foot. The money stock can never be properly managed by any attempt to control the cost of credit.
If you look at the one-year change in total reserves has been increasing, stoking inflation.
https://fred.stlouisfed.org/series/TOTRESNS
I don't see prices declining until June-July.
The inflation lag is part of how the poor get poorer. When money supply increases, rich folks take out loans to buy whatever, the new money spreads through the economy (lag). At the end of the line, people at the bottom of the ladder suffer with the inflation as the lag effect occurs. Those people get the inflation tax, while the folks at the top enjoyed the new money before the lag happened.
The rich are getting richer, as always.
hey scott - welcome back - you have been in the no recession camp for some time - are you growing more concerned the fed is going to potentially stay tight for too long - bonds are at similar levels to when inflation was running at a much hotter pace so now real rates even more extended than before which is perhaps reason for concern here - the market is finally correcting and many rates sensitive stocks (consumer / housing) are down 10 to in some cases 30% - time for caution or you are still constructive? - thanks
Re chances of recession: I worry a bit more these days about a recession, and if there is anything out there that might precipitate a recession, it would be the Fed's desire to keep monetary policy tighter for longer. However, I still see no signs of a recession on the horizon. Swap and credit spreads remain very low, the banking system is flush with liquidity and financial conditions are quite healthy, the stock market is healthy, the dollar is strong, unemployment claims are low, job gains continue at a reasonable pace, and there is virtually no risk of an imminent increase in tax or regulatory burdens. The major source of immediate worries is the geopolitical situation which is well known and has been for some time.
So I worry a bit more, but in the absence of concrete examples of deterioration I remain constructive on the economic outlook.
https://t.co/2ACohiR5Al
"Javier Milei announces Argentina’s first quarterly fiscal surplus since 2008, promising his commitment to eliminating deficits won’t waver"
Scott,
I am an institutional advisor and like to use interesting charts when I find them for my clients. Could I have permission to use you charts on inflation?
Probably the most important economic variable to the well-being of the average citizen is employment/unemployment. A few others that are very high on the list are, gasoline price inflation, housing affordability and small business surveys. The latter three are in poor shape. Here is the small business chart:
https://strgnfibcom.blob.core.windows.net/nfibcom/optimism-graph-march-2024.png
There have been some episodes in the past several decades where a recession isn't happening, but the average American feels economically stressed- late '70's, ~1992-1994, 1999-2000, ~2016. We might be in another one of those times.
JJ: you're welcome to use any of my charts.
Thank you Scott. By the ave clients in the western core plus for over 10 years.
Dennis Gartman posted a Federal Researve chart on M-2 and has utterly collapsed into negative territory.
I recently read your insightful post titled "Belated March CPI Analysis" and was impressed by your detailed breakdown of the latest Consumer Price Index data. Krazycouponclub
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