When Velocity Feels Like Acceleration

By: Michael Ashton | Tue, Mar 29, 2011
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Continuing the list of exciting news that equity investors consider to be bullish, today the debt of Portugal and Greece were downgraded by S&P, and the Syrian Prime Minister resigned due to the continuing protests in that country. Treasury yields edged higher again (10y yield is now at 3.49%) and Crude Oil rose - continuing to toy with the $105 level on WTI.

Consumer Confidence was weaker-than-expected at 63.4, due to a sharp decline in the expectations component. But some observers had been bracing for even worse, due to the sharp decline in the Michigan Confidence figure, and stocks began to rally as soon as the number printed. After all, 63.4 is still pretty high compared to where it was last year, although it does bear remembering that the low print of confidence in 2003 was 61.4 (see Chart).

Conference Board Consumer Confidence
The current level of confidence looks high only because it got so low.

People (thanks, JH!) made a big deal about the 1-year-ahead consumer expectations for inflation that came out of the Consumer Confidence data. That number jumped to 6.7%, the highest since the energy spike of 2008 (see Chart). Initially, my reaction was that this simply was a trailing indicator indicating the recent rise in gasoline prices. But when you look at the chart on a longer-term basis, it's really quite fascinating.

Consumer Confidence 1y-ahead inflation expectations
Consumer Confidence 1y-ahead inflation expectations

Inflation expectations were actually considerably lower in the early and mid-90s, despite the fact that inflation was demonstrably higher (see Chart below; compare to chart above).

The uptrend in expectations doesn't seem to be grounded in the reasonably-stable trend CPI.

Now, why this is fascinating goes to the next chart. The upper chart is the level of front Crude Oil futures; the bottom is the 12-month change in crude oil futures.¹ That is, the top chart is the price level, and the bottom chart is analogous to inflation, which measures the change in the price level.² This is where it is interesting to me. The Consumer Confidence index of year-ahead inflation expectations is clearly tied more to the level of gasoline prices than it is to the change in prices! And that is unexpected (to me) and surprising.

And it has some interesting implications for policy (continuing yesterday's conversation, which if you missed it you can find here). The Fed's view is, as they have repeatedly stated, that they can be measured with removing stimulus because consumers' inflation expectations are "well-anchored." In modeling, the usual assumption is that inflation expectations are related in some way to recent inflation, or trend inflation, or something like that. These charts suggest that consumers are responding to visceral sensations much more than is generally assumed. When prices were low, even a large percentage change didn't bother the consumer, because at the margin it wasn't changing his lifestyle much. At a higher level of prices, suddenly people notice the effect that the prices are having on the wallet, and translate the "I don't like this" feeling into a sense that there is inflation.

I've written previously about some of the other cognitive biases we bring to the table when we consider inflation but this is a phenomenon I hadn't included and probably ought to be.

The implication for central bankers is that even if energy prices (and even more importantly, food prices) flatten out so that they are not going up any more - and thus, food and energy inflation will revert to zero after a year - consumers may still encode a high level of inflation expectations because of the level of prices.

And that would really suck, to use a technical term. Because the Fed has very little control over the level of gasoline prices, especially if the world is retreating from nuclear power and there is anything to the "Peak Oil" hypothesis. Inflation expectations could come unmoored even as inflation itself was contained.

In that case, the Fed better hope that the "anchoring" hypothesis is false, since that anchor will be dragged to a new anchorage!

Again, note that there isn't anything the Fed could do about this, besides trying to be extra hawkish and convince everyone that despite the high level of prices they don't need to fear inflation. But I am still not convinced that despite St. Louis Fed President Bullard's supposition that the Fed could trim $100bln from QE2 the central bank actually will do anything. I think that most Fed officials view the costs of tightening too early as much higher than the costs of tightening "a little" too late. And while I think that pulling back on some of the liquidity might not be a bad thing, as it would help take some of the steam from equity and commodity markets, that isn't the same as saying that it would be helpful to shoot interest rates much higher.

At least, that's true with respect to near-term growth. It might be better in the long run to deflate this liquidity now rather than later, even if it means another recession right now. But I don't think Fed officials think that long-term, and the only way they'll tighten is if they really do convince themselves that hiking short rates and selling a trillion in bonds won't cause interest rates to rise. They seem to be talking themselves into that one.

Tomorrow we start the Employment-week windup with the ADP Employment figure (Consensus: 208k from 217k). Even at the peak of the last recession, ADP never got much higher than this for any length of time, so expecting a big gain here is probably not a high-odds bet. At the same time, the underlying strength seems real even if it could prove to be ephemeral given other crosscurrents, so I wouldn't want to bet on a sharp shortfall. And let's face it, whatever comes out is likely to be construed as good for equities, until suddenly it isn't. I have no insight as to when that will happen.


¹ The picture is similar if I use actual retail gasoline prices, but the series on BBG only goes to 1993 and I wanted the Gulf War spike.

² Let this dispel any arguments about whether I am using "manipulated CPI figures." I assume we can all agree that spot futures contracts are a pretty free market. (Incidentally, the monthly correlation between the level of gasoline prices and the level of the CPI Energy price index, back to 1993, is 0.988 so those dastardly economists at the Bureau of Labor Statistics are obviously very crafty about hiding their manipulation!)



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

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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