The Bloom Is Off All Roses
It is always so gratifying when the most-exciting day of the month is CPI day. It makes me feel like I picked the right niche.
On the other hand, when the reason for that excitement is only somewhat related to CPI, and when that day produces a sharp rally and higher inflation right after I had suggested it may be time to short TIPS, it does tend to take some of the bloom off the rose.
But then, the bloom appears to be off roses everywhere. Wednesday's data will conjure up many headlines and articles containing the word "stagflation," many of them written by twenty-somethings who have never seen odd-even rationing (I have nothing against the young. I hope to be one again someday).
The inflation data were surprising, but that wasn't the only surprise. The Empire Manufacturing index was not a surprise but rather a shock, printing -7.79 when +12.00 was expected. While the Empire is a volatile index, that's a rather big miss.
The morose growth message was compounded by the significant weakness in the NAHB Housing Market Index, which is not normally a market-mover but which dropped to 13 from 16 (expected to be unchanged), matching last year's low print.
The main data event was CPI, though, and it surprised on the high side. Both headline and core came in 0.1% higher-than-expected, but the +0.287% rise in core inflation is the real story. The year-on-year rise in core is up to 1.51%, approaching the full-year projections of many economists half a year early.
This rise is starting to be flattered (and flattened) once again by the slower rise in Housing inflation. Core ex-housing (see Chart) is up to +1.83% from 1.08% back in December. While it had been up to almost 3% in late 2009, the upward direction has been re-established fairly clearly.
Core ex-housing turning higher again.
It's important to realize why it makes sense to look at ex-housing core inflation. In most cases, taking ex-this and ex-that is dangerous because you risk removing important information from the data. If you're removing something that is rising slowly, you're after all biasing the number higher. If you're concerned about outliers, you can merely turn to Median CPI (+1.5% y/y in May), 16% Trimmed-Mean CPI (+1.9% y/y in May) or some other measures of inflation's central tendency and leave everything in.
However, Housing is different because Housing is coming off an asset-price bubble, and as a result prices are going to be less-sensitive to monetary policy simply because the bubble is deflating (although a fair case can be made that prices are back roughly to fair, in which case ex-housing is less compelling). A policymaker doesn't want to focus on parts of the economy that are temporarily insensitive to policy, in order to calibrate policy. If core inflation is rising at 2%, while core ex-housing is rising at 5%, and the central bank obsesses on the former, then it is committing a policy error (even though 2% in that case would be a fairer measure of the price changes consumers are actually experiencing).
There are other things to consider that inform the question of whether this month's 0.3% is a one-off or whether it augurs a further acceleration in inflation. Breaking down the CPI into the eight major groups is an instructive exercise. In May, the only group that did not see inflation accelerate on a year-on-year basis was "Other Goods and Services," which is a mere 3.5% of the overall basket. The chart below shows the change in the y/y readings.
|Weights||y/y change||prev y/y change|
|Food and beverages||14.8%||3.363%||3.057%|
|Education and Communication||6.4%||1.029%||1.004%|
|Other Goods and Sservices||3.5%||1.517%||1.931%|
One year ago Housing, Apparel, and Recreation were all contracting; only Recreation is still doing so and only just. The smaller groups are more volatile, and less "sticky" in general, but when they are all going the same way it has potential significance in the same way that the sudden co-movement of all the different commodity markets last September carried significance. It increases the possibility that there is a common tide - inflation - that is lifting all boats. It doesn't guarantee that is the case, but it increases the odds.
So with the signs of price inflation, one would expect the bond market to sell off (and, with weaker growth as well, you would expect stocks to do poorly). But the reality was quite contrariwise. Bonds shot higher, because of another little detail that was unrelated to the data today.
The bailout package for Greece (I should say the 'next' bailout package) appears increasingly unlikely to happen. This shouldn't be a big surprise since all of the participants have previously staked out positions that are not easily compromised (especially since those positions were made very public). The BBC took it a step further, reporting that Commissioners "fear future of eurozone."
On the plus side, the first step to recovery is admitting that you have a problem.
So Greek 10y yields reached 17.44% today, a new high, and the Euro (bless its poor misbegotten heart) was hammered as if the market wanted to break it into its constituent pieces through brute force. The kneejerk response is to buy U.S. bonds for the flight-to-quality, sell commodities because a stronger dollar tends to weaken demand for commodities denominated in dollars, and sell stocks. I can't say I disagree with any part of this formulation in the short run, although it bears noting that any effect of FX movements on consumer inflation is relatively small and operates at a long - multiple years - lag.
On the day the S&P fell -1.8%, the yield of the 10y Treasury dropped 13bps to 2.97%, and the 10y TIPS yield fell 8bps to 0.69% (real yield). NYMEX Crude dropped 4% to 95.32, grains were -2%, softs were -2.2%, and industrial metals -1.2%.
Lost in the chaos of the day was the headline overnight that Fed officials are "said to discuss" adopting an inflation target. This is not exactly man-bites-dog since the Fed has been discussing it for at least a couple of years. The real question is not whether they do inflation targeting at some point - they will - but whether they do inflation rate targeting or price level targeting. Kahn wrote an important paper on the subject a couple of years ago, and if you're curious about the topic I discussed it here. To summarize, price-level targeting makes much more sense than pursuing a short-term inflation rate target but regardless of what they do it will take a long time for them to figure out what approach to take even if they're sure they want to do it. The lay person thinks it sounds very easy to institute an inflation target, but in fact it is a complex multi-faceted decision which requires a lot of discussion. From a market standpoint, we haven't heard enough speeches yet about the different types of inflation targeting for me to think it's very close. Before the Fed announces any such thing, we will all know it is coming.
I don't think that having an inflation target is a good idea. The Fed already has an implicit one, so an explicit one just means that if they miss the target they lose explicit credibility (see "Bank of England"). But anyone waiting around for Bernanke to make a clever move had better be talking about chess because he has manos de piedras when it comes to making good long-term policy decisions.
Is this week over yet? Not yet. On Thursday we'll be treated to Initial Claims (Consensus: 420k vs 427k last), Housing Starts (Consensus: 545k vs 523k last) and the Philly Fed index (Consensus: 7.0 vs 3.9 last). After today's data, some economists might want to tweak those figures, but "no backsies."
Stocks are in a bad place, and for Treasuries the view appears glorious. It is much easier for the former situation to persist than for the latter. Commodities took another bruising today but it was mostly in the energy group; the commodity indices still haven't done enough damage to the technical picture to be sure of another leg down. Similarly, the dollar is gravitating toward the 76 level on the dollar index again, but there is a bit of wood to chop before it breaks free into a bull move.