We Are Increasingly Moving Into A One-Way Street For Central Bank Policy

|
 |  Includes: DIA, QQQ, SPY
by: Michael Ashton

Thursday was CPI day, which after Christmas and Thanksgiving is one of my most favorite of days. Here is what I tweeted earlier (and there’s lots more commentary below):

  • Unrounded core CPI at +0.18%, a bit higher than what dropped off. Not exactly alarming, but higher than Street expectations.
  • Y/Y core to almost exactly +2.000%. Apparel rose again after the recent rise had slowed in the last couple of months.
  • Subindices: ACCEL: Housing, Apparel, Transp, Food/Bev (75.2% of basket). DECEL: Med Care (6.9% of basket). UNCH: Recreation, Comm/Ed, Other
  • OER was unch…rise in Housing came from primary rents (that is, you actually pay rent) and lodging away from home.
  • Core goods inflation stayed stable at +0.7% y/y; core services stable at +2.5%. I think the former number is going to rise.

This was actually something less than the most exciting CPI report in history. It was better than the Street expected, and although the year/year figure barely nudged higher, the components of the number were strong. The rise came from Housing, which ought to continue to accelerate for a while given rental tightness and other forward-looking indicators, and Apparel resumed its rise as well.

See the chart below (source: Bloomberg) for the update to what is rapidly becoming one of my favorite inflation-related charts.

Click to enlarge

The Cleveland Fed’s Median CPI dropped just enough to round down to +2.2% on a y/y basis, and the Atlanta Fed’s “Sticky” CPI is also at 2.2%. These measures are other ways to look at the central tendency of the inflation figures, and suggest that the current 2.0% from the traditional Core CPI is likely to converge higher rather than vice-versa.

But Thursday didn’t change any inflation paradigms.

There was other news, however, that struck me as inflation-related and worth commenting on. One was a story in the UK Daily Mail citing the case of a Denny’s franchisee (he owns a few dozen Denny’s restaurants) who is planning to add a 5% “Obamacare surcharge” to customer dining checks.

Now, the sum of all of the sales of this man’s Denny’s restaurants is a tiny part of the CPI category “Food away from home,” which is itself a small part of CPI, so it won’t have any impact on the numbers. Even if lots of restaurants followed suit, it wouldn’t have much of an impact since “Food away from home” is only 5.6% of the consumption basket (so a 5% surcharge on all checks would cause a rise in CPI of 0.28%), but it serves as a good reminder of one important point.

The higher taxes and other costs of doing business that are going to be targeted at business is going to show itself to individuals one way or the other. The higher cost of Obamacare compliance, and any other increased business taxes, will not be paid by businesses for the simple reason that businesses are pass-through entities. That is, businesses don’t make money; people who own businesses (partners or shareholders) make money. So whether the higher costs show up as higher prices to the consumer (in which case the government’s attempt to raise revenue from business will result in higher inflation prints, as the transition takes place) or as lower profits to the businesses themselves, the cost will end up being borne by real humans.

At the end of the day, how much of these costs is absorbed by the owners and how much is paid by the consumers is determined by the elasticity of supply and demand for the product. For example, if the elasticity of demand is infinite, then the owners will bear the entire cost; if the elasticity is zero, then consumers will pay it all. My personal guess is that given the current level of gross margins, more of these taxes and higher costs will be paid by owners – implying lower equity earnings – than by consumers, but we will see. But notice that either way, you get lower real earnings. Either nominal earnings fall, or prices rise. Not good for stocks in either case; bad for bonds in the latter case, too.

Then there are the actions of several central banks in the other hemisphere. A story in the Wall Street Journal, and echoed elsewhere such as in this Australian news outlet, suggests that the Reserve Bank of Australia has adopted a form of QE by allowing its foreign currency reserves to rise in order to push down the currency. The RBA has been one of the bastions, at least relatively, of ‘hard money’ in a world of central banks that have gone wild, so this isn’t a positive development unless you’re long inflation-related assets.

And also hard to miss were the comments by the leader of Japan’s main opposition party, Shinzo Abe, who may become the next Prime Minister quite soon. Abe suggested that the Bank of Japan should target 3% inflation, rather than 1% inflation, and threatened to revise the law that (supposedly) insulates the BOJ from politics. Note that 5-year Japanese inflation swaps are near all-time highs, but still only at 0.77%, and 10-year inflation swaps are at only 0.48%. Under Abe’s pressure, we would likely see a substantial acceleration in QE by the BOJ, which has already succeeded in pushing core inflation in Japan from -1.6% to -0.6% over the last two years (see chart, source Bloomberg).

Click to enlarge

We are increasingly moving into a one-way street for central bank policy. Central bankers are essentially engaging in a sophisticated version of competitive devaluations. The Fed does QE, the BOE does QE, the ECB does QE (but claims it doesn’t), the SNB and BOJ and now the RBA does QE. It is a one-way street because whoever stops printing first will see his currency shoot higher as investors flock to the harder currency. The chart below shows what has happened to the Aussie dollar over the last decade versus the USD. While the strengthening trend was interrupted by the 2008 flight-to-quality, it quickly resumed. Since that time, it has risen roughly 50% (and 100% overall since 2001).

Click to enlarge

Now, a strong currency is good. It makes foreign goods cheaper and raises the standard of living overall. However, it also hurts exports, which slows the economy and results in visible layoffs while the economy adjusts. There’s only so much of this a country’s politicians are willing to take, and it seems Australia may have reached its limit.

If everyone is printing, exchange rates may not move at all. It has frustrated many dollar bears that the greenback hasn’t declined under the profligate printer Bernanke; printing money is supposed to destroy a currency. It has done so repeatedly over the course of history, and it happens for obvious reasons: when you get a bumper crop of something, its price tends to fall. More supply induces lower prices. In this case, it induces a lower price of a currency unit in terms of other currency units.

But that only happens if the relative supply of a currency is changing. If everyone is printing at roughly the same pace, there is no reason that currencies should move at all relative to each other. They should all fall relative to non-printers, or to hard assets. And that’s why it’s even more incredible that commodities are not shooting higher. Yet.

Those effects, in my view, absolutely swamp in importance the weak growth news we’re getting these days. Thursday, the Philly Fed report and Initial Claims were both quite weak, but the data is going to be polluted by hurricane Sandy for a while and hard to interpret. I don’t think the hurricane had anything to do with this story, or its timing for that matter:

FHA Needs Bailout From Treasury to Plug Budget, Bachus Says

Nov. 15 (Bloomberg) — The Federal Housing Administration will need billions of dollars in aid from the U.S. Treasury before the end of the year to fill a financial hole caused by defaults on mortgages it insures, House Financial Services Committee Chairman Spencer Bachus said today.

… The agency is “burning through” its last $600 million and FHA officials have briefed him that they will need a financial backstop within a month, the Alabama Republican said during a press conference in Washington.

So we are trying to figure out how to raise a trillion dollars over ten years to start closing the budget gap, but it helps to remember that there are other groups who are going to be bellying up to the bar for a hit of government help. The FHA, the postal service (-$15.9bln this year, although they expect to lose only $7bln next year), probably California before long. We’d better get our act together quickly…but as yet, there is no sign of it. Nice of Bachus to wait until less than a month before the FHA runs out of money to mention this, by the way.

And I haven’t even mentioned the sudden explosion of violence in Israel, which doesn’t give the impression of a fire that will quickly burn out. It may not spin out of control, either, but it bears watching very closely since our influence in the region has significantly ebbed since the change of control in Egypt, our exit from Iraq, and our distancing from Israel.

I don’t think 2013 is shaping up to be a very fun year. But we’re not there yet!