Ever since Fred Sheehan published his post on the bifurcated view on "The ‘Flations", I have been using this as a baseline way of talking about prices. Easy monetary policy is geared to raising prices. However, if the secular trend is toward debt deflation, you have two forces competing against one another. Central bankers will tell you they have control over prices. Hence, Ben Bernanke’s quip that "a determined government can always generate higher spending and hence positive inflation." But central planning can only control so much in a large, open economy. Some prices will be inflating, others will be deflating.
This was my point in the Flation Scylla and Charybdis post last year when I said:
In my view (and apparently in Bernanke’s), both inflationary forces and deflationary forces will be at work for some time to come. This will present policy makers with a problem as the reflation trade comes good, and the resulting policy responses will have serious implications on the medium term outlook for the economy and asset markets.
So that is the lens through which I view the US government report on record low core US inflation. Commodity prices have risen and will pass through. Rental prices are rising in previous bubble markets like Southern California. Gasoline prices are up as are food prices. In fact, many of the things which disproportionately affect lower wage earners are starting to increase (see yesterday’s post On Food Price Inflation). In my view, the low core inflation is very much at odds with the rise in the more volatile and necessary elements of where wage earners spend money. One can only hope this divergence ends of its own accord rather than via demand destruction as it did in 2008.
A well-regarded equity analyst wrote in a similar vein in his evening note tonight regarding the equity markets. He notes, some prices are going up while others are going down:
“Benign” CPI data was just what the Fed doves needed to stem the bleeding in the Treasury debt and stock markets and by Jove they got it. Before I break down the CPI release, I want to draw your attention to the below chart which shows the E-Mini S&P 500 futures (green) and the 10-year T-note yield (white) on an intraday basis going back to November 3rd when QE2 was formally announced. The chart is sourced with permission from Bloomberg L.P. and the annotations are mine.
The above chart shows that while the magnitude of the moves in the two markets (stock futures and bond yields) doesn’t always match up perfectly, the timing of the moves does. The stock market is incredibly sensitive right now to fluctuations in the Treasury debt market. When yields rise, stocks fall, and when yields stabilize or fall, stocks catch a bid. I’ve identified events that are politically QE2 supportive in blue while events that are critical of or cast doubt upon QE2 are in pink. The chart’s a bit noisy but what you need to know is that there’s a text explanation for each vertical pink and blue line and that the text hugs very closely to the line it’s explaining. I’d like to make just a couple observations about this noisy chart before I go on to the CPI data.
1. The E-Minis ran into resistance at 1182 this morning and that’s no surprise given that 1182 was the level at which they found support in the wake of the QE2 announcement back on November 3rd. I’ve highlighted that support-turned-resistance dynamic with the horizontal red lines on the chart. This is a market that is very conscious, technically, of the QE2 announcement. Breaking down through that key level yesterday, rallying back to it and then failing today makes for a textbook bearish pattern, but this market has made mince meat out of anyone trading off of such bearish cues. Can you say head fake? July 2009 and September 2010 were both epic head fakes – bearish signals that didn’t lead to bearish outcomes – that I’ll probably never forget. So I’m wary of reading too much into this…but I have to point out that the signal is there. At the very least, know that 1182 in the Minis is a key level.
2. The 10-year T-note yield is higher right now than it was before this morning’s dovish CPI data hit the tape at 8:30 a.m. I’ve identified this on the chart with small yellow circles. In other words, even though every headline you’ve read today is some variation of “CPI data calms nerves over Fed’s QE2 program” or “CPI data validates Fed’s decision to embark upon QE2,” the bond market is telling us that that is the wrong conclusion. The bond market is telling us that a single benign (a.k.a. deflationary or more appropriately “disinflationary”) CPI print is not strong enough medicine for what ails it. We even had repeat dovish performances from Boston Fed President Rosengren and St. Louis Fed President James Bullard this morning and yet the comments weren’t dovish enough, apparently. My feeling is that the Fed is losing its power over the bond market.
Enough about QE2 and the markets – between this note and the previous two recaps I think I’ve made my point that either the Fed’s program is failing or it’s being made to look as though it’s failing for political reasons (I’ve gotten pushback on this “conspiracy theory” but these are high stakes games being played and after TARP and FinReg I wouldn’t put it past them). Let’s just take a quick look at the CPI data to make sure we’re not missing anything.
Let’s start with the weightings so we have a feel for what categories actually have enough heft to move the headline index: Housing is largest at 42.0%, then Transportation at 16.7%, Food & Beverage at 14.8%, Medical Care at 6.5%, Recreation at 6.4%, Education & Communication at 6.4%, Apparel at 3.7% and finally “Other” at 3.5%. “Other” includes tobacco and smoking products as well as personal care products and services and other “miscellaneous personal services.”
I’ve pasted 6-year charts of these eight major categories below in order of their weightings. If you’re reading this on a BlackBerry I recommend you open up the PDF at some point and take a look at them because they really paint a picture. If we admit that the housing category, 60% of which is an approximation of how much it would cost to rent one’s own home, is really only applicable as a cost to those who rent, then we can say that the three next biggest categories – transportation, food & beverage and medical care – are all going higher. Sure, recreational prices are down and education prices are tailing off, but the prices of the true necessities of life are going higher – and this is hedonically adjusted data! As Lee Quaintance and Paul Brodsky of QB Partners are fond of saying, the Fed is worried about falling prices alright, but not the prices we think they’re worried about!