The Fed Needs More Inflation Nerds

By: Michael Ashton | Mon, Jan 30, 2017
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Earlier today I was on Bloomberg<GO> when the PCE inflation figures were released. As usual, it was an enjoyable time even if Alix Steel did call me a 'big inflation nerd' or something to that effect.

The topic was, of course, PCE – as well as inflation in general, how the Fed might respond (or not), and what the effect of the new Administration's policies may be. You can see the main part of the discussion here, although not the part where Alix calls me a nerd. A man has some pride.

My main point regarding the PCE report was that PCE isn't terribly low, but rather right on the long-run average as the chart below (all charts source Bloomberg) shows. Of course, PCE has been lagging behind the rise in CPI, but because it had been "too tight" previously this isn't yet abnormal.

CPI and PCE YoY

However, in the interview I didn't get to the really nerdy part. Perhaps my ego was still stinging and so I didn't want to highlight the nerdiness?[1] No matter. The nerdy part is that the reason PCE is low is actually no longer because of Medical Care, but because of housing. This next chart plots the spread of core CPI over core PCE, through last month's figures, versus Owners' Equivalent Rent (OER).

CPI

Housing has a much higher weight in the CPI than in the PCE, and as you can see the plodding nature of OER means that the correlation is somewhat persistent because housing inflation is somewhat persistent. Right now, OER (which, frankly, I thought would have leveled off by now) is rising and showing no signs of slowing, and this fact has served to widen the CPI-PCE spread back to its historical average and likely will cause it to widen to an above-average level. I suppose the good news there is that it is still true that outside of housing, core inflation is still not rising aggressively. Core services ex-housing are looking perkier, but core goods continue to languish as the dollar remains strong. The strength of the dollar almost beggars belief if it's true that the rest of the world hates us now, but it is what it is.

The bigger point, for markets, is "so what?" There is nothing about a 1.7% core PCE that presents any urgency for Chairman Yellen. As I said on the program: as Yellen approaches the end of her chairmanship (in January 2018, since she insists Trump won't chase her out before), I believe it is much more likely that she wants to be remembered for pushing the unemployment rate very low – because she believes inflation is easily controlled – than that she wants to be remembered for being a hawk that stopped inflation from getting going. She isn't worried about inflation, and so the question is whether she wants to be criticized for adding "too many" jobs, or not adding enough. Not that monetary policy has much to do with that, but I believe she clearly will err on the side of keeping policy too loose. The Fed isn't tightening this week, and I find it unlikely that they will tighten in March, unless inflation expectations rise considerably further than they have already (see chart of 5y5y inflation forward from CPI swaps, below). Even after the big rally since late last year, 5y5y is well below the long-term average through 2014.

5y5y

And even if inflation expectations do rise further, the excuse from the chair will be easy: expectations are rising because the end (and possible reversal) of the globalization dividend and the imposition of tariffs will lead to higher prices. But there is nothing that Fed policy can do about this – it is a supply-side effect, just as high oil prices due to OPEC production restraints would represent a supply-side effect that the Fed shouldn't respond to. So the excuses are all there for Dr. Yellen. History will show that she missed a chance to shrink the Fed's balance sheet and avert the worst of the next inflationary upturn, but that history will not be written for some time.

 


[1] Ridiculous, of course. I embrace my nerdiness, at least when it comes to inflation.

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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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