Summary (and Extension!) of My Post-CPI Tweets

By: Michael Ashton | Fri, Jan 16, 2015
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Below is a summary and extension of my post-CPI tweets. You can follow me @inflation_guy:

This was a wild report, full of interesting items. Let's start with Apparel. In recent years, I have watched Apparel closely because one of my theses was that the domestic benefit from exporting production to cheap-labor countries was ending. Apparel is a nice clean category that went from normal inflation dynamics when most apparel was produced domestically (prior to 1993), to disinflation/deflation over the years where virtually all production was moved offshore, to normal inflation again once the cost savings on labor had been fully realized and so no longer a source of disinflation (at which time, costs ought to begin to track wage inflation in the exporting country, adjusted for currency moves).

CPI-Apparel Seasonally Adjusted

While it seems that the recent decline should challenge that thesis (and that was my knee-jerk reaction), I think that perhaps it isn't quite as clear-cut as I thought. In the past I had ignored the effect of foreign exchange movements, since (a) it didn't matter when we were mostly domestic production and (b) over the last few years currencies have been broadly stable. I think the latest decline in apparel is almost surely related to the dollar's strength, which unfortunately means that it isn't as pure a test of my thesis as I had hoped. In any event, apparel is one place (one of few, in the US) where dollar strength manifests clearly in core goods prices, so this is a dollar effect.

The next chart is the chart of Medical Care Commodities (mainly pharmaceuticals). Remember when we had that quaint notion that the Affordable Care Act (Obamacare) was going to permanently reduce inflation in medical care? (Actually, we didn't all have that quaint notion - in particular, I did not - but it was certainly a view pushed very hard by the Administration). It turns out that the decline in medical care inflation was mostly due to the effects of the sequester on Medicare payments, and now prices seem to be catching up. This is an ugly chart.

Medical care Commodities y/y

Ex-medical care commodities, however, it doesn't appear that disinflation in core commodities will be in for much of a respite unless the dollar rally is arrested.

Core CPI ex Medical

And now for one of the scariest charts: core inflation ex-shelter is as low as it has been since the early 2000s, when the uptick in housing costs (like now) hid a close scrape with deflation. I think the causes of that deflationary scrape were similar to those of today, if in fact we are going to head that way: too much private debt. Although the higher level of public debt makes the answer more indeterminate, high private debt imparts a disinflationary tendency. The "deleveraging" was supposed to get rid of the disinflationary tendency by moving private debt onto the public balance sheet. It really didn't happen, except for auto companies and some large financial institutions like Fannie Mae.

Core CPI, Core ex-shelter

The important difference between now and then is that in the early 2000s we had higher rates, higher velocity (which is correlated to rates) and no excess reserves. Today, all the Fed would need to do to arrest this tendency would be to lower the interest on excess reserves to a significant penalty rate and those excess reserves would quickly enter the money supply. Interestingly, a movement the other way - to raise interest rates - will likely also cause inflation to rise as it will raise money velocity. So I am not particularly concerned we will get into deflation even ex-housing. There are lots of ways out of that pickle. I am much more worried about overreaction. Once again, the Fed might have stumbled into the right policy: doing nothing. If you can't be lucky.

One final remark on our "inflation angst" index (not shown here): the rise in the index, which manifests itself in a perception that inflation is actually higher than reported, is driven by the increasing volatility of index components (such as airfares, gasoline, and apparel) and the increased dispersion of index components (such as apparel and medical care commodities). These both have the impact of making inflation feel higher than it actually is. It is nothing to worry about at these levels of inflation, because "higher than it actually is" still feels low. But if inflation volatility continues to pick up as the level picks up (as it eventually will), then it will feel much worse for consumers than it actually is. That's not a 2015 story, however.

Keep in mind that the market has already discounted really bad core inflation for a long time. We are very unlikely to get such a bad outcome, unless housing collapses - which it might, since prices are getting back into bubble territory, but I don't think it's very likely. As a consequence, even such a bearish inflation report as this one has been followed by a rally in inflation swaps and breakevens. I think this is a wonderful time to be buying inflation. It's hard to do in the retail market, although the Proshares UINF ETF is a reasonably clean way to be long 10-year breakevens. It is $28.80, and I expect it to be at $36 within 6-9 months.


Disclosure: Neither I nor any entity or fund owned or controlled by me owns this ETF or has any current plans to buy or sell it.

You can follow me @inflation_guy!

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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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