Page 10 News

by: Michael Ashton

On Friday the BLS released the monthly CPI figures, and there was again a little gasp when an 0.3% on core inflation graced the tape. This month’s 0.254% was only barely rounded higher, but considering that many economists had been expecting last month’s jump in apparel and other “volatile” core components to be reversed this month, it was impressive nonetheless. The year-on-year figure didn’t quite make it to +1.7% (+1.639%, actually), but this constitutes a second consecutive monthly surprise and the first time that consecutive 0.3% prints in core inflation have been seen since June and July 2008, when the year-on-year rate was 2.5%. Before that, the last time was January/February 2001, when the y/y rate was 2.8%. And before that, you have to go back to March and April 1995 when the y/y rate was 3.2%.

That’s right: In the last 16 years – 195 months to be exact – there have been exactly three prior episodes of consecutive 0.3% prints in core inflation, and in each of those was a much smaller aberration from the monthly run rate at the time.

Unless, of course, the true underlying run rate of core inflation is not the latest 1.6% print but something higher. For the first half of this year, core CPI rose at a 2.5% pace, and that is with shelter, ~41% of the core index, rising at only 1.6% annualized.

In Thursday’s article, I promised a chart of core inflation ex-shelter. That chart is below, but I introduce it with a reminder that the reason it makes sense to strip out housing – although I am usually reluctant to strip out one component or another – is that housing was in a bubble through the latter part of the 2000s, and has been unwinding that bubble ever since 2008. It is unreasonable to think that monetary policy operated over a normal range to have much impact on a portion of the economy that is recoiling from a bubble; moreover, while shelter is a large component of consumers’ basket it isn’t what they see every day. Looking at Core ex-Shelter is a good way to get a simple view of broad price pressures that consumers are facing (incidentally, the chart says “ex-housing”, but it is actually ex-shelter, a subtlety that only matters if you’re an inflation guy or an economist, but I thought I’d make it clear).

The assumptions I’ve made in the projections below are very simple. I assume that core slackens to a 2.0% pace in the second half of the year and shelter, which has been at 1.2% over the last year and 1.6% in the first six months, drops back to a 1.2% pace in the second half. That’s a pace roughly consistent with the current level of housing inventories.

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See text for the projection assumptions.

With those parameters, in December core inflation reaches 2.25%, but core ex-housing gets to 3.04%. Obviously, if overall core inflation stays at a 2.5% pace, or if shelter inflation slackens further (as there are some signs it may), the core-ex-shelter number could be even higher. As the chart shows, there has been a general uptrend in core inflation if you take away the housing bubble, since a low not in 2010 but in 2003. That uptrend should reach new 18-year highs this year.

Other economic data on Friday was also discouraging, although the stock market managed to shrug off all of the bad news and post a nominal gain along with bond prices (the 10-year yield fell to 2.91% and the 10-year TIPS to 0.54%). The Empire Manufacturing Index, which economists expected to rebound and demonstrate that last month’s swoon was an aberration, instead stayed negative at -3.76 (versus +5.00 expected). The Employment subindex dropped sharply, from around 10 to near flat. Later in the morning, the Michigan Confidence number, which economists expected to rise to 72.2 from 71.5, plopped to 63.8. That is the lowest confidence number since March 2009, the latest in a growing string of numbers to echo that refrain.

The bond rally, then, is easy to understand but why did stocks nudge higher? There were two reasons that the optimists carried the day. The first is that there was news the House of Representatives is planning to vote on a $2.4 trillion debt limit increase, combined with spending cuts, a cap on spending, and a proposed Constitutional amendment to balance the budget. (Most states have such amendments. It isn’t a great idea but it’s like throwing away the cookies if you’re not able to be disciplined about keeping away from the cookie jar.) The presumption is that this is a political gambit by the Republicans to force the Democrats in the Senate to vote against the debt limit increase, thereby highlighting the differences in fiscal responsibility. However, two can play at that game and as long as it stays a game we’re no closer to a deal. I stand by my view, though, that some deal will be reached to raise the ceiling by enough to make sure the administration doesn’t need to choose whether to pay for essential government services or the bond coupons. It is just too easy to avoid the contrived crash. It would certainly be ironic if we were to put ourselves in the dock rather than waiting until the people who lend us money eventually do it.

The other reason equities rallied is because of the sweet credulity of equity guys. The European Banking Authority announced the results of the latest round of "stress" tests on European banks. Only eight institutions failed (16 “just missed”), and only two of those in Greece. That constitutes your hint, because if Greek debt is at risk of default surely every Greek bank would fail, right? It turns out that if Greek debt is in the "hold to maturity" book, rather than the trading book, then it isn’t subject to stress because no amount of economic weakness can cause a sovereign to default. Really.

The stress scenario was to assume an 0.5% economic contraction in the euro area in 2011, plus a 15% drop in European equity markets and some modest trading losses (around 22 cents from par on Greek bonds) of sovereign bonds not in the hold-to-maturity book. So one way to think about the stress tests is that eight banks failed assuming a garden-variety recession, without an equity bear market, and with Greek bonds rallying about 50% from here (from $0.52 to $0.78). I think it’s fair to assume that those other 16 banks would have failed the test under even slightly more-challenging (or less-political) assumptions.

Bond investors just held their sides and had a good belly-laugh on that one, but equity investors decided the coast was clear and that it was time to stick the head up out of the burrow where they have been all week (similarity to the game “Whack-A-Mole” intended).

One of the reasons I write this commentary is because I will occasionally be forced to think of something I would not have thought about on my own. Someone on Friday was quizzing me further on why M2 was growing (a topic I discussed last Thursday, then again on Sunday and on Wednesday this week), and asked about whether money leaving the euro for dollars could be the culprit.

I responded:

“No, because that doesn’t change the amount of money – if you sell euros and buy dollars, you’re buying them from someone who already had dollars.

“Now, if you’re BORROWING them from someone and lending euros, then that could increase M2 if it’s a bank lending you dollars. It is possible that more people are borrowing from U.S. banks than from European banks ... I never thought of that, but maybe ...”

It would be interesting if the relative strength of U.S. banks meant that relatively more lending is being done in dollars because of the euro crisis. In that case, the euro crisis would be causing U.S. money supply to expand, and perversely causing U.S. inflation. What a twist that would be! Thanks to the reader who provoked this realization with a thoughtful question.

And by the way, it remains a timely topic since M2 continued its surge this week. The 13-week growth rate, which had been 12% (annualized) last week, rose to 14.9% this week. The 26-week growth rate was 7.5% and rose to 10.1%. And the 52-week growth rate, which ordinarily moves in quite staid fashion, rose from 6.3% last week to 7.7% this week. Those are again highest-since-2009 numbers (see chart).

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It almost looks like the money supply chart just hit buy stops.

The recent surge should be disturbing, and it is. But it isn’t yet in investor consciousness yet. It’s page 10, moving forward I think. And that means I am waiting for the debt ceiling deal to be announced, and hoping that it gets announced before M2 moves to page 1. I think I want to be short bonds when it gets to page 1.