Inflation Worrying People Less, But Shouldn't Be

By: Michael Ashton | Wed, Oct 19, 2011
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Well, it's definitely getting difficult to attract followers to websites these days. I noticed that one of the visitors to my main commentary website got there by following a link from a Google search of "fraud michael ashton accused." For the record, as far as I know I have never been accused or even suspected of fraud, but one takes website hits as one can, I suppose. Won't you help improve the provenance of my visitors by passing along the commentary to a friend and pointing them to the website, syndicated versions of the comment on Seeking Alpha or Safehaven, or the Twitter feed @inflation_guy?

Despite my apparently impending legal problems, it was still an interesting day because it was CPI day.

Headline inflation was as-expected at +0.304%, but core inflation came in at only +0.054%, barely rounding up to +0.1%. That really wasn't too much of a surprise; I commented yesterday that core inflation had been running hotter than my models suggested it should be. What was a little surprising was that housing inflation wasn't responsible for that slowdown. I show the breakdown by major groups below.


Weights Y/Y change Prev Y/Y change Year ago y/y
All items 100.0% 3.868% 3.771% 1.144%
Food and beverages 14.8% 4.471% 4.372% 1.364%
Housing 41.5% 1.818% 1.627% -0.265%
Apparel 3.6% 3.521% 4.183% -1.196%
Transportation 17.3% 11.842% 11.684% 4.610%
Medical care 6.6% 2.813% 3.194% 3.412%
Recreation 6.3% 0.283% 0.063% -1.316%
Education/communication 6.4% 1.123% 1.094% 1.642%
Other goods and services 3.5% 1.294% 0.878% 2.524%


From last month, the following major subgroups showed acceleration in the year/year rate: Food & Beverages, Housing, Transportation, Recreation, Education/Communication, and Other. Those groups total about 90% of the index; the other 10% (Apparel and Medical Care) decelerated. Now, this is on a year/year basis, and it doesn't tell you where the weakness was this month, but what it does tell you is that overall inflation is still rising. The year/year figure for headline was +3.868%, as you can see from that chart, and core was +1.975%. Remarkably, coming off a bubble bursting Housing inflation has almost caught up with the rest of core. I think this is largely a blip resulting from the hang up in processing foreclosures, and I would expect Housing to fall further behind core over the next six to twelve months.

Now, that could happen if housing kept rising at 1.8% but core ex-housing kept quickening. In fact, that would be good for the economy, or at least the housing part of it, since nominally-rising prices will help clear the inventory overhang more quickly. Any way you slice it, inflation right now is still rising. The fact that y/y core inflation rose despite the small m/m change tells you that last September's core figure was even lower. It was, at +0.03%, and October's was +0.01%. That could hint at some problems with seasonal adjustment, or perhaps it was just the low point of the cycle.

As an aside, the Cleveland Fed's Median CPI rose to 2.1% year/year.

The bottom line is that right now there is no reason in the data to think that inflation pressures will abate. As long as the pumps are on, the basic assumption should be that the price level will continue to rise. Once the pumps are turned off, inflation will tend to ebb. The real questions now are (a) is there any will to turn the pumps off, and (b) given the reservoir of reserves, will we need to reverse the pumps...and is it possible...and is there any will to sell trillions of dollars of the Fed's balance sheet into the market to compete with new Treasury issuance. The answers to those questions, of course, are unknown.

Now, there is another possible reason to think inflation will ebb (I'm talking about core inflation here; headline inflation will ebb for at least a little bit reflecting the flattening of energy prices unless there is a spike higher). A story on Bloomberg this morning announced that:

"Banks in France, the U.K., Ireland, Germany and Spain have announced plans to shrink by about 775 billion euros ($1.06 trillion) in the next two years to reduce short-term funding needs and comply with tougher regulatory capital requirements, according to data compiled by Bloomberg."

If you don't want to worry about inflation, this is the reason. If banks unwind loans, rather than selling other assets like sovereign bonds, then it represents a decline in credit availability that will manifest as a deceleration in velocity. Of course, if they sell bonds from portfolio instead, at the same time that sovereigns are selling ever more bonds, then interest rates will likely go much higher since banks have been big buyers of those bonds historically. That will slow growth, although it won't do a lot to slow inflation.

This was after all part of what the Fed was trying to offset with QE1: they expected a sharp fall in velocity and needed to offset it with a rise in money. (It isn't at all clear what they were trying to do with QE2.)

Now, it is plain that concern about inflation is ebbing at least among retail investors. The NYSSA recently postponed a course I was scheduled to give on "Understanding Inflation-Indexed Products," until such time as "the economy reaches an inflationary trend" (which is a really amazing statement when you consider that core inflation has more than tripled in the last year and is still rising). Institutional investors are still devoting considerable time to hedging adverse outcomes in inflation, but retail investors are clearly less concerned. The chart below, which shows the aggregate adjustment to measured inflation suggested by my "Real Feel Inflation" methodology,¹ can be read as a measure of inflation angst, and it is quite low at present.

A measure of inflation angst - fewer price outliers feels less inflationary to us.

Retail investors generally assume that inflation is related to growth (institutional investors do too, but are generally aware of the money argument), which is why commodity prices these days ebb and flow on an almost 1:1 basis with stocks. When stocks are rising, because of a report that there's a grand solution to the European mess that will curtail the possibility of a meltdown, then commodities rise as well - as they did on Tuesday. When stocks are declining, because it turns out that the aforementioned report was bunk and in fact Euro leaders are meeting "to Break Debt-Crisis Gridlock," then commodities fall as well - as they did today.

As an aside, the quote of the day comes from that article:

"Many expect to be underwhelmed at the weekend," David Mackie, chief European economist at JPMorgan Chase & Co., said in an interview. "If they haven't settled the leverage issue, then the sense of being underwhelmed will be overwhelming."

Even those who believe that growth matters a lot to inflation, however, could be a trifle more optimistic today after Housing Starts sharply exceeded expectations by printing 658k compared to a 590k expectation. As the chart below shows, this isn't exactly "Happy Days Are Here Again!" but it is improvement...and the fact that it was ignored underscores how the market right now eats, sleeps, and voids Europe in preference to all other information.

Nice jump in starts, but in the grand scheme of things no big deal.

So, because Europe is now seeing "division,' stocks fell 1.3%, commodities fell 1.3% (all subgroups participated in the decline), inflation swaps declined about 4bps, and nominal yields declined 2bps.

Tomorrow brings Initial Claims (Consensus: 400k vs 404k last), Existing Home Sales (Consensus: 4.91mm from 5.03mm) and the Philly Fed Index (Consensus: -9.6 vs -17.5 last). There's also the auction of $7bln 30y TIPS, which should clear at a real rate somewhere right around 1%. That is only a good deal if your alternative was to buy 30-year nominal Treasuries at a yield of 3.18%; you'll very likely do better owning 30-year TIPS. But the real question is why you'd take 30-year risk at rates this low. They're not all-time lows (yields got as low as 0.82% earlier this month), but close enough that I wouldn't buy them.

Also tomorrow, I plan to present one way to consider whether commodities are "in a bubble." (I'd intended to cover it today but ran out of space.)


¹ The methodology is discussed in my paper 'Real-Feel' Inflation: Quantitative Estimation of Inflation Perceptions, which is scheduled to be published in the January 2012 edition of the journal Business Economics. My company is looking for a commercial partner to further develop the methodology - contact me to discuss.



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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