Ugly CPI

By: Michael Ashton | Wed, Sep 17, 2014
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Here is a summary of my post-CPI tweets.

I am still breathing heavily after this truly shocking number. This sort of inflation figure, outside of a crisis or post-crisis recovery, is essentially unprecedented. Lower prints happened once in 2010, once in 2008, three times in 2003, and once in 1999. But otherwise, basically not since the 1960s.

The really amazing figure is the core-ex-Housing number of 0.91% y/y. A chart of that (source: Enduring Investments) is below.

core-ex-Housing vs Core CPI

There are interesting similarities between the current situation and late 2003, which is the last time that ex-housing inflation flirted with deflation. Between late 2000 and June 2003, money velocity fell 11%, in concert with generally weakening money growth. Velocity fell primarily because of a sharp decline in interest rates from 6% on the 5y note to around 2.25%. The circumstances are similar now: 5y interest rates declined from around 5% to 0.5% from 2006 through mid-2013, accompanied by a 24% decline in money velocity. And voilá, we have weakness in core inflation ex-housing.

The important differences now, though, are twofold. The first is that the absolute levels of money velocity, and of interest rates, are much lower and very unlikely to fall much further - indeed, money velocity is lower than it "should" be for this level of interest rates. And the second is that there is an enormous supply of inert reserves in the system which will be difficult to remove once inflation begins to rise again. The Fed began to increase interest rates in 2004, which helped increase money velocity (and hence, inflation) while it also caused M2 growth to decline to below 4% y/y. Core inflation rose to 3%, but the Fed was basically in control. Today, however, the Fed has no direct control over the money supply because any reserves they remove will be drawn from the "excess" reserves held by banks. This will make it difficult to increase overnight rates except by fiat (and increasing them by setting a floor rate will merely cause money velocity to rise while having no effect on the money supply). So the 'potential inflation energy' is much higher than it was in 2003. As an aside, in 2004 I was quite vocal in my opinions that inflation was not about to run away on the upside, which is another key difference!

If you are a tactical inflation trader, today's CPI figure should make you despise inflation-linked bonds for a few weeks. But they have already taken quite a drubbing this month, with 10-year breakevens falling from 2.27% to 2.08% as I type. It's okay to watch them fall, tactically, especially if nominal bonds generally rally. But strategically, not much has changed about the inflationary backdrop. I don't expect airline fares to continue to drop. I don't expect Medical Care inflation, which has a strong upward bias due to base effects, to plunge further but to return to the 3%-4% range over the next 6-12 months. And Housing inflation slowed slightly this month but remains on course to continue to rise. So, if you are considering your inflation allocations, this is a good time to increase them while markets are dismissive of any possibility of higher prices.

Without a doubt, today's number - especially following another weak CPI print last month - is a head-scratcher. But there aren't a lot of downside inflation risks at the moment. Our forecast had been for core (or median) inflation to reach 2.6%-3.0% in 2014. I would say that core CPI isn't going to get to that level this year with 4 prints left, and even median CPI (which is a better measure right now of the central tendency of inflation, thanks to the aforementioned base effects in medical care, and remained at 2.2% this month) is going to have a harder time reaching that target. I'd lower and narrow the target range for 2014 median inflation to 2.5%-2.8% based on today's data.

 


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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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