A return to relative tranquility

This is a short note to highlight the significant decline in market volatility over the course of the past year.

Price volatility is often thought of as "fear" that stems from uncertainty. The Vix Index, technically defined as the implied volatility of equity options, is the most common measure of volatility in the stock market, while the MOVE Index uses the implied volatility of Treasury bond options. The expected and implied volatility of prices underlying each index is a key determinant of the price of related options contracts. Higher expected volatility drives the price of options higher, and vice versa. Since purchasing options contracts reduces and investor's risk, options are highly prized (and thus more expensive) during periods of market distress. During periods of relative calm, investors are less likely to purchase options, and thus their prices decline. 

Chart #1

Chart #1 compares the Vix Index (white line) to the MOVE Index (orange line). Not surprisingly, both tend to move in tandem, but not always to the same degree. The last significant increase in volatility occurred last Spring, when Trump shocked the world with huge tariffs on U.S. imports. As the chart shows, volatility has subsided meaningfully since the Spring peak, and it now approaches levels which in the past have been associated with relatively calm (and often optimistic) equity and bond markets. 

The current relatively low level of both volatility indices is in many ways equivalent to a market-based measure of investors' confidence or sentiment. The market has lost its fear of tariffs, as many have been reduced or eliminated, and those remaining have failed to move the needle on inflation (as any economist worth his salt would have predicted) and do not appear to have posed much of an obstacle to growth (though I think the economy would be stronger without them). The principal value of Trump's tariffs derives from his ability to use them to achieve certain worthwhile objectives (e.g., reciprocal reductions in tariffs with some of our trading partners).

Improved confidence in the future is a good thing in and of itself, since it surely promotes greater saving and investment, which ultimately translate into more and better-paying jobs and higher living standards. On the other hand, finding good values in a period of tranquility becomes harder, and the market becomes more susceptible to disappointments. There's no free lunch, but things could certainly be a lot worse than they are today.

Lots of things are looking up

Valued readers, please excuse me. For the past few months I've suffered from writer's block complicated by a lack of government-produced data. I now have some facts to work with, and they look pretty good. I've assembled a baker's dozen of my favorite charts here, and I will try to keep the commentary lean and let the charts do the heavy lifting. It feels a lot like Christmas!

To sum up: The economy is in decent shape (2-3% growth) and inflation remains subdued (2.5% or less). More specifically, the M2 money supply is growing at a very moderate 4.5% rate and most if not all of the $6 trillion increase in M2 that was "printed" during the Covid era has been absorbed. There is still no evidence that Trump's tariffs have boosted inflation. The main source of slightly-above-target inflation in recent years can be traced to the government's faulty measurement of housing and shelter costs, and these have finally subsided and should remain low (if not negative) for the foreseeable future. 

Commodity prices (abstracting from gold, which appears to inhabit an alternative universe) are very well behaved, and haven't shown any meaningful increase for years. GDP growth was surprisingly strong in Q3/25, and Trump's Big Beautiful tax cuts, coupled with impressive deregulation and an actual shrinkage of the public sector workforce, have set the stage for continuing growth in the coming year. It is comforting to see a 4-5% increase in business investment so far this year (e.g., capital goods orders and shipments), and it is now common knowledge that AI is already contributing to improved productivity. Finally, it is also VERY comforting to see that federal government spending has not increased at all over the past 12 months, while revenues have surged by almost 10%! 

Chart #1

Chart #1 shows the level of the M2 money supply, arguably the best measure of readily-spendable money. It grew at a 6% pace from 1995 through 2007, during which time inflation averaged about 2%. Then all hell broke lose: M2 surged by some $6 trillion in a 2-yr period, fueled by Covid stimulus spending which was effectively monetized. That bulge now has all but disappeared.

Chart #2

Chart #2 shows the 6-mo. annualized growth rate of M2, now a mere 4.6%. The economy is now on a low-inflation monetary diet. As I have said about M2 many times in the past 5 years, this is arguably the biggest news that no one, not even the Fed, is paying attention to. 

Chart #3

Chart #3 shows the ratio of M2 to nominal GDP. I call this the "demand for money," since it essentially measures how much of our annual incomes we prefer to hold in the form of money. Money demand surged in the first year or so of Covid, because people were terrified and largely unable or unwilling to spend all the cash the government was doling out. Strong money demand effectively neutralized the surge in the M2 money supply, which explains why inflation didn't start rising for a year after M2 began to soar. Money demand then collapsed beginning in mid-2022, as things began to return to normal, and that effectively offset the collapse and actual shrinkage of M2—that's why a contracting money supply didn't cause the recession that was so widely anticipated. (Remember: inflation happens only when the supply of money exceeds the demand to hold it.) Now money demand is almost all the way back to where it was prior to Covid.

Chart #4

Chart #5

Chart #4 compares the strength or weakness of the dollar to the level of inflation-adjusted spot commodity prices, while Chart #5 shows the nominal level of those same commodities since early 2020. These are all very basic commodities, not the sort that are subject to speculative pressures (like gold can be). What we see here is a very strong inverse correlation between the dollar and real commodity prices. A stronger dollar tends to coincide with weaker commodity prices, and vice versa. Note that commodity prices over the past 33 years haven't changed at all in real terms, and the dollar has only strengthened modestly. Over the past several years, commodity prices have gone nowhere—a strong symptom of an absence of underlying inflationary pressures.   

Chart #6

Chart #6 is structured the same way as Chart #4, except that I've used the inflation-adjusted price of crude oil. In real terms, oil prices are relatively low, and that reinforces the outlook for low and stable inflation. Oil is the most volatile of all commodity prices, and the price of energy is an important contributor to the economy's health. Nationwide gasoline prices are currently just under $3 per gallon, and that is roughly what gasoline prices have averaged over the past 20 years. This is very good news for economic growth.

Chart #7

Chart #7 looks at the short-term, annualized rate of change in Owner's Equivalent Rent, which in turn constitutes about one-third of the CPI. In the past two months, this important component of the CPI has decelerated markedly; this will subtract meaningfully from reported inflation over the next 10 months.

Chart #8

Chart #8 compares the year over year change in the total CPI to its ex-shelter version. The gap between the red and blue lines over the past 2 years is largely due to the government over-estimating shelter costs. The gap has now all but closed. 

Chart #9

Chart #9 shows the long-term growth trend of real GDP (green line), which averaged about 3.1% per from the post-war period through 2007. Sadly, the economy has yet to return to those glory days; growth has averaged only a bit more than 2.3% per year since the Great Recession ended in 2009. Why this huge shortfall? I suspect a variety of culprits: massive increases in transfer payments (e.g., green energy subsidies, Obamacare), burdensome regulations (e.g., CAFE standards), and DEI hiring, to name a few. Stepping back, mankind has spent several trillions of dollars on inefficient energy projects in a vain attempt to "save" the planet from climate change. A return to efficient energy investment appears already to be underway. This is great news for the planet and its economies.

Chart #10

Chart #10 tracks the growth of private sector jobs in recent years, which are now growing at a snail's pace. Contrast this to the surprisingly strong growth of Q3/25 GDP (4.3%) and you must conclude that productivity is on the rise by more than enough to offset the drag of massive deportations of illegals. Meanwhile, federal government payrolls have shrunk by 9% (273K) so far this year! To my mind that's the equivalent of pouring much less sand into the wheels of commerce. 

Chart #11

Chart #11 shows the inflation-adjusted price of gold over the past 113 years. Monetarists like me have trouble reconciling soaring gold prices with an apparent absence of inflation pressures. Central banks have meaningfully increased their purchases of gold in the past four years, and that at least partially explains gold's rise to levels never before seen—or even imagined. On the other hand, this could be a classic case of speculative froth which eventually exhausts itself and collapses. The 30% collapse in Bitcoin prices since early October could be a harbinger of trouble ahead for other markets. 

Chart #12

Chart #12 paints a disturbing picture, suggesting that the recent collapse in bitcoin could be presaging a similar decline in equity prices. The market cap of crypto currencies peaked at $4.28 trillion on October 6th, and current stands at $2.95 trillion; $1.33 trillion of paper wealth has thus evaporated in a matter of weeks. Dabble in gold and bitcoin at your peril. I wouldn't touch the stuff—give me real, productive assets instead.  

Chart #13

Chart #13, in contrast, paints a hopeful picture; federal government finances look to be returning to some measure of sanity. Federal government spending has been flat for the past year, while revenues have increased by 10%. The days of $2 trillion dollar annual deficits are fading fast. Federal debt owed to the public has been 90-100% of GDP for over 5 years (it peaked at 103% in mid-2020) and may soon begin to decline. In the meantime, the true burden of our national debt is currently 3.7% of GDP, and that is significantly less than the 4.5-5% levels which prevailed during the 1980s. There is still reason to be optimistic.

Happy New Year!

P.S. Thanks to Larry K for the words of encouragement!

A brief update on M2

This post is an update of a thesis I have been working on for many years. It's based on a fundamental tenet of Milton Friedman, who taught us that inflation happens when there is an oversupply of money relative to the demand for it. Newer readers might want to read my description of how I learned to understand this while living in Argentina, and how this helped me predict the big jump in US inflation in the 2021-22 period.

For the past two years money demand has stabilized as M2 growth has picked up moderately. The "bulge" in M2 money supply has been almost completely absorbed by economic growth, with the result that there is no longer a monetary source of inflation that the Fed needs to stop—higher interest rates are not necessary. M2 money supply is once again growing at a 5-6% rate, which is similar to what we saw in the period from 1995 through Q1/20—a period when CPI inflation averaged about 2%. Given 

Chart #1

Chart #1 shows the level of the M2 money supply, which grew at a fairly steady rate of about 6% per year from 1995 to just prior to the Covid panic. M2 subsequently exploded as the government "printed" some $6 trillion to pay for an avalanche of Covid-related checks to the population. The Fed began to reverse this process in mid-2022, by raising interest rates and slowing the growth of M2, which has grown by only $500 billion since its 2022 peak. M2 today is only about $1.4 trillion above where it would have been if the 1995-2020 trend growth had continued.

Chart #2

Chart #2 is my way of measuring money demand: M2 divided by nominal GDP. The ratio is a proxy for the amount of readily spendable cash that people want to hold as a percentage of their annual income. For many years (50s, 60s, 70s, and 80s) money demand was fairly stable. That is what led Milton Friedman to assume that the velocity of money in his famous equation (M*V=P*Y) was relatively constant. But as we have learned in recent decades, that is a highly questionable assumption. In my way of looking at things, the demand for money should be the focus (money demand is the inverse of money velocity), since it ties in with the theory that the price level changes when the demand for money exceeds the supply of it. 

Sharply rising money demand in the wake of Covid effectively offset the sharp increase in money supply, as evidenced by the fact that inflation didn't pick up until 2021, when money demand started to plunge but money supply remained relatively constant. 

Today, Chart #2 tells us that money demand has ceased falling and is picking up just a bit. Combined with the fact that money supply is growing at a "normal" rate, we should expect to see inflation decline modestly, which in fact it has if we exclude shelter costs.  

Chart #3

Chart #3 makes a very important point: the growth of private sector jobs has decelerated significantly in recent years. However, the growth rates shown are most likely overstating the true growth rate, given the relatively large downward adjustments the BLS has made after the fact, and especially considering the magnitude of deportations in recent months. True jobs growth might well be only slightly more than half the rates shown in the chart. That amounts to a significant headwind to economic growth, and it has also contributed to depress confidence (most of measures of which are at relatively low levels). Any loss of confidence is likely to increase the public's demand for safety—and money hoarding is a natural response to that. Weak economic growth is likely fueling at least a modest increase in the demand for money. The Fed should respond to this by relaxing policy. And they have, reducing the federal funds rate by a quarter point recently. More cuts are likely in order and I hope they follow soon. 

Inflation is not a virus, and it's not going up

Inflation is not like a virus that spreads through a population. A rising price in one part of the economy cannot "infect" a price in another part of the economy. A currency doesn't just "catch" inflation because oil prices go up or a drought causes wheat prices to rise. Inflation is the result of an imbalance between the supply of money and the demand to hold it. It's a monetary phenomenon, as Milton Friedman taught us. And it generally results in a rising price for most goods and services.

The reason inflation appeared to rise last month, as the August CPI report implied, is not because of a monetary imbalance. As the charts below will show, the bulk of the apparent rise in inflation can be traced back to the way the BLS calculates inflation in the housing sector. There's another factor at work as well: the BLS can and does make mistakes, and numbers are typically volatile from month to month. Seasonal adjustment factors can be off and in need of revision. Consumer preferences for many goods change as prices change, but the BLS is slow to pick that up. The change in one month's number does not reliably mark a change in trend.

Chart #1

The Producer Price Index for Finished Goods (Chart #1) is a great illustration of the rather explosive inflation episode which the economy experienced from early 2021 to mid-2022. Prices were rising slowly from 2015 through 2020, then suddenly rose by more about 27% from early 2021 to mid-2022, only to once again resume a slow rise from mid-2022 through today. The fuel for that price explosion was a $6 trillion increase in the M2 money supply, a subject I've covered extensively in prior posts. From mid-2022 to August 2025, prices have increased at an annualized rate of only 1.4% with little or no sign of any meaningful acceleration. The return to low and relatively stable inflation was preceded by a dramatic contraction in M2.

Chart #2

The Final Demand version of the PPI (Chart #2) shows the same pattern. Although it rose at an annualized rate of 2.2% over the past 3 years, it is up at only a 1% annualized rate in the past six months.

Chart #3

Oil prices (Chart #3) show a rather sharp increase from 2021 through mid-2022, but they haven't increased at all since pre-Covid times. Since mid-2022, oil prices have actually fallen by 40%! Non-energy commodity prices have fallen by almost 10% since March '22. If inflation is on the rise, someone forgot to tell the commodity markets.

Chart #4

Chart #4 shows that the BLS's calculation for housing inflation today (which they call Owner's Equivalent Rent, or OER) is closely related to the year over year change in national home prices from 18 months prior. Today, home prices nationwide are barely increasing and are very likely to decline. Yet the BLS calculates that housing-related costs rose 4% in the past year. 

Chart #5

Chart #5 looks more closely at the behavior of housing inflation according to the BLS. In the past month, BLS calculates that OER rose at a 4.7% annualized rate, and is up at a 3.9% annualized rate over the previous 3 months. At a time when national home prices are on the verge of falling (and rents are flat to down), the BLS figures that housing inflation is accelerating! Trump is right to want a change in BLS leadership.

Chart #6

Chart #6 shows the 6-mo. annualized change in the CPI versus the ex-shelter version of the CPI. Without OER inflation, the CPI has been increasing at about a 2% annual rate for the past 3 years, and the rate of change has actually fallen to a mere 1.7% over the past six months. This means that the uptick in CPI inflation in August was driven by a big increase in the OER component of the CPI, as shown in Chart #5. 

Chart #7

Chart #7 shows the ratio of M2 to nominal GDP. I think that's a good proxy for money demand. Thanks to a big slowdown in M2 growth over the past three years, the amount of readily spendable money in the economy (M2) is almost back to pre-Covid levels. Excess money has been absorbed, and money demand is stabilizing. Thus, there is little or no reason to worry that inflation is coming back to haunt us.

California's Bullet Train Boondoggle

California voters approved the now-infamous high-speed-rail project in 2008; it was projected to cost some $33 billion and was to encompass some 800 miles, connecting Los Angeles to San Francisco, and the Central Valley to coastal cities, with an expected completion date of 2020. As I recall, the feasibility study for this project assumed that revenues from the LA-SF segment alone would exceed revenues from all other Amtrak lines in the country. After 17 years and over $15 billion in spending, not a single mile of track has been laid. Projected costs have tripled, and the scope of what is left of the project will deliver a 119-mile segment in the Central Valley, with no connection of SF or So. California. 

It is a manifest failure, and a monument to the fantasy that modern government can successfully and efficiently undertake complex projects. In just two decades, and for a tiny fraction of the cost of California's bullet-train boondoggle, Elon Musk's SpaceX has proved that point, going from zero to wildly successful and profitable, leapfrogging all other nation-sponsored space undertakings in the process. 

My good friend, talented artist, and fellow free-market advocate Nuni Cademartori has penned the cartoon which follows. May this boondoggle never be repeated, and may it swiftly be put out of its misery!

For more of Nuni's editorial artwork, check out my posts using this link. 

P.S. And may Gavin Newsom NEVER become president of the U.S.!

The appeal of small-cap stocks

Since March 2021, on a total return basis, small cap stocks have underperformed large cap stocks by almost 60%, according to Bloomberg. While surging prices for tech stocks (e.g., the Fab 7) go a long way to explaining why this has happened, it's also likely that tight monetary policy in recent years has also boosted large cap stocks at the expense of small caps. This case was bolstered by today's price action which followed Chairman Powell's speech in Jackson Hole, in which he indicated the Fed is getting ready to resume the easing of monetary policy that started two years ago but which has stalled since then.

Today was a good day for all stocks, but small cap stocks advanced 2.3% more than large cap stocks. So far this month, the total return on small cap stocks has exceeded the return on the S&P 500 by 4.7%. The following charts are telling us that this dynamic could have a lot more room to run.   

Chart #1

Chart #1 compares the level of the S&P 500, the most popular and well-regarded index of large cap stock prices, with the Russell 2000, the equivalent index for small-cap stocks. Over time, the chart shows that these two indices have experienced gains of similar magnitude, but there are times when they diverge. The two y-axis values are based on the fact that the S&P 500 index value tends to be about double that of the Russell 2000 index; or conversely, the Russell value tends to be about half that of the S&P 500. 

Background info: The Russell 2000 index contains the smallest 2000 stocks of the Russell 3000 index, and has a current market cap of about $3.1 trillion. The S&P 500 index, in contrast, has a market cap of about $55 trillion, and is composed of what could arguably be termed the 500 largest and most successful companies in the U.S. It's hard to imagine two indices with greater differences: big and successful vs. very small and obscure—David vs Goliath. Yet there are times when small caps outperform large caps, and we could be at the beginning of one of those times.

Chart #2

Chart #2 shows the ratio of the Russell 2000 index to the S&P 500 index. Small cap stocks have underperformed large caps by roughly 40% over the past 12 years, with the ratio declining from 0.64 to 0.36.  Over the period shown, the ratio has averaged 0.5, and it appears to be mean-reverting. Should the ratio revert to 0.5, that would imply a small-cap outperformance of roughly 35%.

Chart #3

Chart #3 compares the ratio of the small cap/S&P 500 indices to the level of the yield on 5-yr TIPS, which in turn is a decent proxy for how tight Fed monetary policy is (it's inverted to show that a rising red line equates to easier monetary policy, and a falling red line equates to tighter monetary policy). With the exception of a few periods, these two lines tend to track each other, thus reinforcing the thesis that monetary policy has an important influence on the relative behavior of small- and large-cap stocks. 

It is commonly thought that easy money is good for small cap stocks because small companies are generally more leveraged and thus more sensitive to changes in interest rates, whereas large companies are less leveraged and thus better able to weather adverse conditions, among other things.

What stands out of late is the divergence of the two lines which began about two years ago; monetary policy has been slowly easing (as seen in the rising red line) but the small cap ratio has been declining. Today's price action—in which small caps outperformed large caps by 2.3%—marks what could be an important turning point in favor of small caps—thus reestablishing historic patterns. Note that a similar (but opposite) divergence happened in the 2005-2008 period.

CPI and GDP update

We've been in Maui the past few weeks on our annual family vacation. The island is still recovering from the Lahaina fires 2 years ago (we were there at the time in happened), but there are finally visible signs of rebuilding. Nevertheless, labor is in short supply and prices at the supermarket are sky-high, and to make things worse the island is suffering from a highly unusual dearth of rain, such that the golf courses have been denied water and are slowly turning brown. We were there when the tsunami warning was issued, but it turned out to be a nothing-burger, at least in northwest Maui.

The charts that follow are updates to the CPI and GDP using data that were released in recent weeks.

Chart #1

Chart #2

Chart #1 shows the 6-mo. annualized rate of change in the CPI and the ex-shelter version of the CPI, while Chart #2 shows the year over year change of these two variables. Over the past six months, both measures of the CPI were at or below the Fed's target. I doubt you heard this news in the media, which is anxious to see inflation popping up everywhere thanks to Trump's tariffs. Over the past year, both measures were a tiny bit above the Fed's target. Is that a cause for concern? Hardly. As you can see from both charts, it is the nature of the beast for inflation to wobble above and below 2% on a month-to-month basis.

Chart #3

The thing to remember is that the source of the past several years' inflation is the enormous growth in the M2 money supply. This "extra" money has by now been largely absorbed, thanks to rising prices and tight monetary policy. This is illustrated in Chart #3. With little or no excess money in the economy, there is no reason for inflation to rise on a sustained basis.

Chart #4

Chart #4 shows the 1- and 3-mo. annualized rate of change of Owner's Equivalent Rent. This makes up about one-third of the CPI, and it has for the past two years been the sole reason that the CPI has been above target for the past two years. As I've explained many times, the way the BLS calculates the shelter component of inflation is highly questionable, and almost certainly based on data that is one and two years old—so that it is a very lagging indicator of the true cost of living. In any event, this measure of inflation has been trending down for almost 3 years, and is currently running at a 3.4% annualized rate. It's almost certain to fall further, given that we know that nationwide housing prices—and rents—have been flat to down for the past year and show no signs whatsoever of rising. As OER declines it will become clear to the unenlightened that inflation is behaving as it should.

Chart #4

Chart #4 shows the growth of real GDP over time, plotted on a log scale axis to better illustrate trend rates of growth. The green line is an extension of the trend that prevailed from the 1960s through 2007 (3.1%). The red line is the trend that has prevailed since mid-2009 (2.3%). Actual GDP tends to wobble a bit from its prevailing trend, but not by much. We're still in a 2% growth world, which is unremarkable. I doubt we'll see any significant improvement for awhile, given all the uncertainties surround Trump's tariffs and deportation policies. Eventually we should see some remarkable improvement, as Trump's attacks on taxes and regulatory burdens begin to reap benefits.

We must never lose sight of the enormous gap between where the economy is today and where it might have been if pre-2007 conditions had prevailed. I estimate the gap between the red and blue lines to be roughly $6.4 trillion. In other words, the economy—and incomes—might have been 27% bigger today if policies had been more sensible and less burdensome. Trump has made it clear he wants the economy to return to a 3% growth path, and for the most part his policies support that goal.

UPDATE (8/20/25): For an extended discussion on possible reasons GDP growth downshifted in the wake of the Great Recession (Chart #4), see this collection of my posts on the subject.

California Leavin'

California, with its fantastic climate, gorgeous geography and huge size, has been a mecca for millions ever since the Gold Rush. Perhaps life here has been too easy for many, and too rich for liberal politicians eager to redistribute the wealth. Democrats especially have found life to be easy, with the party having a virtual lock on state and local power centers. 

Government has become increasingly lazy and disfunctional; the roads are a mess, traffic is the bane of everyday existence, taxes and regulations are oppressive, and modest cottages start at $1 million. Famously, Los Angeles can't even keep the fire hydrants and reservoirs full. Not surprisingly, there is an ongoing exodus of state residents and many of its major corporations. The state has spent tens of billions of dollars on an absurd "bullet train" without managing to lay even one foot of track. Thank goodness Trump has put this project out of its misery. The scattered bridges and columns that have been completed should be left standing for future generations, as monuments to the stupidity and corruption of our politicians. 

As a 5th generation Californian, with ancestors dating back to the Gold Rush, it pains me to post these facts: Grok reports that "Between 2020 and 2025, approximately 500 companies have moved their headquarters out of California or shifted significant operations elsewhere, with a notable spike in relocations since 2019. From 2018 to 2021 alone, the Hoover Institution reported 352 companies relocating their headquarters out of the state."

Nuni Cademartori, my good friend and great artist, penned the above cartoon which I featured in a post almost five years ago. Back then it seemed like there was little hope for any change on the horizon.  

Sadly, things have just continued to get worse. The only thing that has changed are the names of the companies opting to move out of California, as this second cartoon illustrates. 

I especially like the signpost on the right: "Gavin Newsom Memorial Highway." Yes, Gavin Newsom deserves full credit for the deterioration of this great state. May this be a warning to the rest of the country. In case you haven't already noticed, our Guv thinks he would be an ideal choice to run the country after Trump. Heaven help us if he gets the chance!

Over the long haul, S&P 500 returns have been impressive

Today the S&P 500 set yet another all-time high of 6,359. 

As the chart below shows, since 1950 the S&P 500 index has increased by slightly more than 8% per year, from 16.79 to 6359. Add reinvested dividends to this and you get a total return of 11.6% per year, according to Bloomberg. If this price performance continues, and given that the current dividend yield on this index is only 1.2% a year, one could expect an investment in the S&P 500 to produce an annualized total return of almost 9.5% per year going forward. Subject, of course, to violent swings along the way, as the chart makes clear.

 

Since 1950, the Consumer Price Index has increased by about 3.5% annualized. This means that the total, inflation-adjusted return of the S&P 500 has been 7.8% annualized over the past 75+ years.

Food for thought!

Inflation remains low

June CPI and PPI figures were released this week, and the buzz centers around whether Trump's tariffs have boosted inflation. There is some evidence in the numbers of tariffs boosting the prices of some goods, but it would be premature—and unwise—to declare that yes, tariffs are causing a rise in inflation. 

Tariffs arbitrarily increase the price of some goods, but that is not the same as monetary stimulus, which is the only thing that can boost the overall level of prices. Absent an increase in the supply of money, higher prices for some goods will almost certainly result in lower prices for other goods. A household on a fixed budget that is faced with higher prices for food will have to cut spending on some other things.

In any event, it's difficult if not impossible to find evidence in the numbers that inflation is rising. Here are some charts to prove it:

Chart #1

Chart #2

Charts #1 and #2 both focus on the CPI and the CPI without its shelter component. The first chart shows the change in these indices on a 6-month annualized basis, whereas Chart #2 shows the year over year change. I fail to see where the latest numbers have changed the overall picture. By any of these measures, inflation currently is somewhere in the neighborhood of 2-2.7%.

Moreover, according to Chart #2, the ex-shelter measure of inflation has been 2% or less for the past two years, as I've been pointing out repeatedly over the past year or so. The reason? The method the BLS uses to determine shelter costs is flawed, as illustrated in Chart #3.

Chart #3

Chart #3 is designed to show that Owner's Equivalent Rent (OER), which makes up about one-third of the CPI index, is driven by the year over year change in housing prices 18 months ago. Talk about lags! The rise in housing prices has slowed significantly over the past few years, and the most recent surveys show that housing prices are actually flat to down a bit over the past year. Yet OER purports to tell us that housing costs have increased by about 4% in the past year. Using a more contemporaneous measure of housing costs would thus yield a much lower overall rate of inflation.

Chart #4

Today the June figures for Producer Prices were released. They show inflation running at 2 to 2.5% over the past year. But as Chart #4 shows, producer prices overall have only increased 0.7% in the past three years, for a 0.2% annualized rate!

Chart #5

Chart #5 shows an index of non-energy commodity prices. Since overall inflation peaked in mid-2022, these prices are essentially unchanged. 

Chart #6

Chart #6 shows the price of crude oil, which is a key determinant of energy prices and which has been extremely volatile over the past 60 years. Since mid-2022, when most measures of inflation peaked, energy prices have been falling.

Chart #7

Chart #7 shows an index of five industrial metals prices, one of which is copper, which jumped 10% 10 days ago, thanks to a new Trump tariff. Still, metals prices overall are unchanged over the past three years. 

Inflation isn't determined by individual prices; you have to look at broad measures of prices over time. Focusing on one month's numbers is a fool's game, since monthly data are notoriously volatile.

Commodity prices have been generally stable for the past three years. This is a solid base for the conclusion that the Fed is doing a good job of keeping inflation low. 

Charts of interest

Some charts I find of interest to the general public, and which you're unlikely to find elsewhere:

Chart #1

Chart #1 sheds light on an important input to the dollar's value: real yields. The red line shows the level of real yields on 5-yr TIPS. These are true real yields, since TIPS are bonds whose principal is adjusted by the CPI, and whose coupon is a "real" yield. (Their return to the investor is equal to the rate of consumer price inflation plus a real yield.) Real yields on TIPS are determined by market forces, and are in turn influenced by the market's expectation of future Fed policy. TIPS are not only safe from default, but also safe from the ravages of inflation. 

The blue line is an index of the dollar's value vis a vis other major currencies. That the two tend to move together suggests that higher real yields enhance the value of the dollar, while lower real yields detract from the dollar's value. The situation today suggests that the dollar is trading on the weak side of where it would normally be given the current level of real yields. This further suggests that investors aren't entirely comfortable with the outlook for the U.S. economy (e.g., tariffs, deportations).

Chart #2

Chart #2 shows my model of the Purchasing Power Parity of the dollar vs. the euro. Currently, the model suggests that the dollar is just about equal to its PPP value against the euro. That further suggests that an American traveling in Europe is likely to find that the dollar price of goods and services there is roughly equal to prices in the U.S.

Chart #3

Chart #4

Chart #3 shows the level of credit spreads on Investment Grade and High-Yield corporate bonds—higher spreads reflecting greater credit risk, and lower spreads reflecting lower credit risk. Spreads today are just about as low as they have been for the past several decades. Chart #4 shows the difference between the two, which is a simple way of judging how nervous the bond market is. Taken together, these spreads are excellent barometers of the health of corporate profits, and by extension, the health of the economy. Conditions are looking pretty good according to corporate bond investors.

Charts #5 and #6

Chart #5 shows the ratio of federal transfer payments (social security, medicaid, unemployment insurance, subsidies, food stamps, etc.) to disposable income. Transfer payments represent money the government gives people money for reasons other than to compensate for their labor. Chart #6 shows the Labor Force Participation Rate, which is the ratio of people working or looking for work divided by the number of people of working age.

The dotted vertical lines mark periods of time when transfer payments ratcheted up rather sharply. That the participation rate ratcheted down each time suggests that people are less willing to work when they receive more money for not working. Funny how that works!

Note the more-than-doubling of transfer payments as a percent of disposable income from 1970 to today. Today, one of every five dollars spent by consumers comes from the government. Viewed from another angle, taxpayers are funding 20% of consumer spending. 

Chart #7

Chart #7 shows the breath-taking growth of federal government spending and tax receipts. Revenues today are more than 5 times what they were 35 years ago, and have increased at a 4.8% annualized rate. Spending today is more than 6 times what it was 35 years ago, and has increased at a 5.3% annualized rate. Our problem is runaway spending, not a lack of taxes.

  

Chart #8

Chart #8 shows the major components of federal revenues. Individual, corporate, and payroll taxes have all increased relentlessly with the passage of time. What stands out here is estate and gift taxes, which today represent a paltry 0.6% of total revenues (~$30 billion per year), and which have not increased at all over the past 25 years. The net worth of the private sector has quadrupled over the past quarter century, but estate and gift taxes haven't budged. This tax could be abolished and the impact on federal finances would be less than a rounding error. Yet this tax gives rise to an army of tax lawyers and accountants, while at the same time diverting trillions of dollars to sheltered investments. It undoubtedly costs the economy far more than the value the government collects. We would all be better off without it.