Still More Regime Change?

By: Michael Ashton | Thu, Mar 17, 2011
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A second surprise higher on inflation was the most significant event of the day from the standpoint of U.S. investors. It also was completely ignored. More on CPI in a moment. Other data was mixed. Initial Claims was as-expected at 385k, but Industrial Production fell short (-0.1% vs +0.6% expected). The Philly Fed index skyrocketed to 43.4, its highest level since 1984 (see Chart). Recall, however, that unlike with the Purchasing Managers' Indices the Philly Fed "General Business Activity" index records the response to a separate question rather than combining the results of the answers to the subindex questions.

Philadelphia Fed Business Outlook
Two weeks in Philadelphia never looked so good!

That matters in this case, because while respondents' assessment of current General Business Activity was very strong, you have to look pretty hard in the ancillary data to figure out what the source of this ebullience is. Prices paid, Prices received, Shipments, Unfilled Orders, Delivery times, and the Average Workweek were all essentially unchanged. Inventories rose to 12.0 from 2.1 and New Orders rose to 40.3 from 23.7; on the other hand, Number of Employees fell from 18.2 from 23.6. Clearly, there is excitement about the level of new orders, but at the same time there doesn't seem to be any excitement about hiring new people! (I have often wondered in the past, but never got around to figuring out how to do it, if the difference between the general index and an index built from the constituents would have any informational value as perhaps indicative of optimism or pessimism not necessarily warranted by the underlying metrics).

But the important release of the day was clearly CPI (not that I am biased or anything). As I said, CPI realized its second consecutive surprise on the high side. The print was 0.199%, so rounding played almost no part in the +0.2% print. Year-on-year core inflation is now at +1.1%, and over the next couple of months it should rise to 1.4% or 1.5% on base effects as a couple of zeroes drop off.

The gains in the index were broad-based. The table below shows the current year-on-year increases in the eight major subindices, as well as those from last month. The quick summary is that only Apparel is decelerating meaningfully and it is 3.6% of the index. Medical Care and Education and Communication neither accelerated nor decelerated from last month. The other 83.4% of the index seems to be accelerating (although "Other" was inflating faster six months ago. It is, however, only 3.5% of the headline index).

 

  Weights y/y change prev y/y change 6m y/y chg
All items 100.0% 2.108% 1.632% 1.148%
Food and beverages 14.8% 2.236% 1.796% 1.000%
Housing 41.5% 0.657% 0.377% -0.391%
Apparel 3.6% -0.421% -0.012% -0.395%
Transportation 17.3% 7.100% 5.419% 4.918%
Medical care 6.6% 2.891% 2.919% 3.168%
Recreation 6.3% -0.143% -0.593% -1.075%
Education and communication 6.4% 1.229% 1.234% 1.929%
Other goods and services 3.5% 1.959% 1.863% 2.948%

 

News stories and analysis today have focused on the notion that "the deflation risk has passed." I have news for ya - the deflation risk was passed when the Fed started buying Treasuries even though the current increase in inflation was baked in the cake over a year ago. I was saying in early 2010 that it was going to be late Q3/early Q4 when core bottomed, and it did so right on schedule. This isn't mysterious! The Fed didn't need to start spraying liquidity into the market again; their belief that they needed to was based on flawed Keynesian analysis in my opinion.

However, housing is still a mess and with the inventory overhang in Existing Homes we're not going to seen a substantial further rise in Housing inflation for a while - at least, based on fundamentals. If we do see housing CPI continue to rise, it's a sign that the Fed's money is getting into that asset market as well and that would not be good.

Equities had a good day, +1.3% on sharply lower volume than yesterday. The VIX, which had risen to near 30 yesterday, retreated to 26.4 today. The nominal bond market sold off a bit and the 10y yield is now at 3.23%. TIPS actually rallied, though, so that breakevens and inflation swaps jumped higher by 6-12bps. It helped the inflation market that oil soared back over $101 and that Grains, Softs, and Industrial Metals were all +3% or better. A weakening greenback helped, but it looks like the people wanting to short what they think is a bubble just got run over by flows.

And there are going to be fund inflows into inflation-related product, even if most available alternatives are pricier than they have been in a few years at least. Higher inflation prints tend to provoke flows into inflation-linked bond funds, commodity funds, and retail inflation-linked corporate notes (also known as CIPS). But consumers were already moving this way. In the latest Michigan Survey, not only did 1-year -ahead inflation expectations rise (they tend to move with actual inflation as consumers project recent moves forward), but 5-10-year-ahead inflation expectations rose as well (see Chart), to the highest level since 2008.

Michigan Survey
Last week's data, but related to today's inflation discussion.

You can see that inflation expectations also bumped higher in 2008, but at that time of course headline inflation was over 5% and core inflation was about 2.4%. In terms of the spread over core inflation, the Michigan numbers haven't been this much extended for at least 20 years (the length of the Michigan data set on Bloomberg). See Chart below:

Michigan survey long-term inflation expectations are at near-record spreads over core CPI
Michigan survey long-term inflation expectations are at near-record spreads over core CPI.

There are two questions here. (1) Why is this happening, and (2) why does it matter (or does it)?

It may be happening for either or both of two reasons. First, it may be that consumers are savvier about Fed monetary policy than we think, or that in any case their confidence in the Fed to engineer a good inflation outcome is diminished. It certainly would not surprise me to find that confidence in the Fed among consumers is at a low ebb, given the spastic nature of the Committee's reactions over the last couple of years and the apparent ineffectiveness of most of what they did (the stuff that was effective, like the commercial paper guarantee facility, is not much appreciated outside of Wall Street). The other reason that inflation expectations may be rising is more related to the way individuals perceive inflation. Clearly, the prices that people pay frequently, mostly food and energy, have been rising rapidly recently. While food plus energy is only 23% of the consumption basket, it carries a very heavy mindshare weight and the now steady and extended trends higher in these consumption items certainly must influence consumers' view of the current and likely future course of inflation.

Why does it matter? First of all, it is possible that it doesn't. We don't really know the role that consumer expectations of inflation play in the process of inflation. However, it should be noted that many economists (not least, those at the Fed) believe that one reason the Fed can run looser policy is that "inflation expectations are well-anchored." The notion is that prices in the economy are set at least partly on the basis of economic actors' rational expectations for price changes, rather than the direct observation of the immediately-preceding price change. Clearly, this must be at least partly true, because if every price change was immediately and frictionlessly transmitted then inflation would have no persistence at all, and if the trend was always immediately and frictionlessly transmitted then inflation would accelerate out of control (or decelerate out of control) with little initial impetus. So clearly, some mean-reversion or dampening tendency must be at work. Many theorists believe that the mechanism is inflation expectations.[1]

I think it could be true that expectations play an 'anchoring' role, but that isn't the last word. The next thing you'd want to know as a policymaker is, what happens to the anchor when it moves? Does it move slowly, like a ship's anchor being dragged along a sandy seabed, or does the line to the anchor suddenly snap, causing the ship to need to drop a new anchor in another location? Here is how the latter situation could manifest. I believe that people do not encode in their heads a precise number for inflation. I think people perceive that inflation is "near zero," or "medium," or "high," and perhaps there's another bucket for deflation.

For small deviations around that anchor, the anchor serves to pull inflation back to the mooring. But how long, or for what size deviation, will the anchor hold if inflation experiences are not matching the expectations-based heuristic that the consumer is using? That is, how long does the price of gas have to rise before I suddenly start expecting it not to be the same on my next trip, but to be higher, and higher again on the next trip?

We don't know. Actually, it's worse than that: we don't have any idea. Actually, it's worse still: as far as I can tell, no one is looking for the answer.

The assumption seems to be that inflation expectations follow some sort of moving average of past experiences. Certainly, the Michigan number shows than when current inflation jumps 1% from its prior reading, the Michigan survey of near-term (1-year ahead) expectations rises about 1%. So it's plausible that expectations smoothly change.

I maintain that this only happens when a given regime is in force. When there is a regime change, you will probably get a non-linear reaction in expectations. This is really hard to test - but it is testable. It is ugly to model - but it is modelable.

From the standpoint of a policymaker, it just means they ought to be very, very careful when there are possible signs that a regime shift could be happening. I don't know whether we are there yet, but the rise in the longer-term Michigan number, coupled with steady increases in food and energy consumables, would make me extra-cautious here.

There is no economic data due on Friday; the Fed will be joining everybody else and purchasing TIPS but otherwise the only significance to Friday is that it is the beginning of the weekend and a 3-day period of uncertainty in which markets cannot respond to developments in Libya or Japan. There may be some resolution in Libya if reports about Gaddafi's gains are correct, and by Monday things in Japan will probably be a lot better but could also be a lot worse. The market's reaction to this uncertainty will depend on how risk-averse investors are. Judging from Wednesday, they are fairly risk-averse right now; judging from today's price action they are instead fairly cavalier. I would tend to put more weight on the higher volume, and although I believe we will get to Monday and feel better about the disaster in Japan I have a feeling that risk-reduction will be more in vogue. I think we'll see stocks lower.

 


[1] It must be noted, however, that we really don't know how to measure true inflation expectations. Asking people what number they attribute to their current experience of inflation is a very unsatisfying approach. You can see something I wrote on this topic last year here, and you can see my academic paper on the subject here.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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