Below is a summary of my post-CPI tweets.
- So I guess the good news this morning is that the market has bigger worries than CPI. Wait, is that good news?
- OK, remember this morning we're dropping off some lousy numbers so core should rise to 2.1% just on base effects.
- But December CPI is always weird, like many December numbers. It's the only month that has a strong seasonal effect on prices (in the US).
- Headline CPI will also rise, y/y, simply because of base effects. Don't think the Fed didn't know this when they tightened!
- OK, +0.1% on core a bit weaker than expected, but y/y still rose to 2.1%. y/y headline to 0.7%, though I don't care about headline.
- Core month/month was 0.13% to 2 decimal places, and forecasters were really looking for 0.18%ish, so not horrible miss.
- y/y core is 2.09% to 2 decimals. I really thought it would go to 2.2% this month, but like I said, December is wacky.
- Next mo we compare to +0.18% in Jan 2015 (on core), so uptick to 2.2% will be more difficult. But core should converge with median.
- OK, in big categories Housing and Medical care decelerated while Apparel, Transportation, and Education/communication accelerated.
- In Medical Care (which is only 7.7% of CPI but high-angst for people), big drop in medicinal drugs to 1.66% from 2.68%.
- That smacks of a seasonal maladjustment. But it's only 1.7% of the basket.
- In Housing, Primary Rents and OER both accelerated, which is what matters. Primaries 3.68% from 3.64%; OER 3.14% from 3.08%.
- Those are the pendulous categories, between them almost half of core CPI, that matter. And they keep going up.
- Lodging Away from Home (small category) dropped to 1.88% from 2.78% y/y. Again, smacks of bad seasonal adjustment.
- Household Energy was also lower. So there you have it - the rent and implied rents continue to go up; the cost of piped gas e.g. not.
- In Transportation, Motor Fuel did better on base effects (only -19.5% y/y!) but insurance, repair, and new cars/trucks were all up.
- Overall, core services remained at +2.9% y/y; core goods rose to -0.4% from -0.6%.
- The continued rally in the dollar probably means core goods will continue to drag on overall CPI. It's not a huge effect but it's there.
- Core inflation ex-housing rose, 1.28% y/y by my calculation, highest since mid-2014. Hasn't been MUCH higher since 2012-13.
- Sorry that's core ex-shelter, not ex-housing.
- So you can think of core CPI as (rents) + (core goods) + (core services ex-rents) + (food & energy). Each roughly equal weight.
- Rents are over 3% and rising. Food & energy weak, core goods weak, core services ex-rents rising.
- Rents will continue to rise. And so median CPI should also. But I am less sure than I have been that the $ will stop strengthening.
- …and less sure that interest rates will rise, pulling up money velocity. So, I will be pulling my forecasts for 2016 lower.
- They will still be higher than everyone on the Street, I am sure. Because they think growth matters a lot for inflation.
- Proportion of CPI that is inflating faster than 3% is at 42.7%. So main body is still between 3%-4% with long negative tails.
- But at least inflation hasn't broadened FURTHER over the last few months. It's been around 42-47% inflating over 3%.
- ..fairly close call, looks like 0.147% on my back-of-envelope, which would make y/y median CPI drop to 2.43% from 2.46%.
- Bottom line is that broad inflation is around 2.5%, but more than 40% of CPI is above 3% and rising.
The broad themes this month are very much in keeping with the (somewhat longer) post-CPI post I wrote last month - the analysis there is worth re-reading as several of these points keep coming up. These broad themes are that (a) rents remain steadily accelerating, and likely will continue to do so because home prices continue to rise between 5-7% per year and rents tend to be driven largely by home prices over time.
The chart below (Source: Enduring Investments) shows that the ratio of median home prices to the level of Owners' Equivalent Rent is again rising. This means that either housing is entering into bubble-pricing territory again, or that OER is going to continue to be pulled higher for a while, or both.
Our models have OER continuing to rise to at least 3.5% (from 3.08%) although our more speculative model has it headed over 4%. Still, if that's as bad as housing inflation gets, and the dollar continues to strengthen, then median inflation will probably not go much higher than 3% because core goods inflation will remain soft while core services inflation will eventually pause.
And the continued - and, to me, confounding - strength of the broad trade-weighted dollar is the real question. The chart below (Source: Enduring Investments) illustrates the connection between the dollar and core commodities. On the one hand, note that even large changes in the dollar have only a small effect on core goods (and on GDP), and essentially no effect outside of core commodities. And, if the dollar merely stops strengthening, then we would expect core goods prices to start rising around 0.5%-1.0%, which would add another few tenths to core CPI.
But, on the other hand, note that the current weakness in core goods is consistent with the dollar's recent pattern of strength, and some deeper analyses/regressions we look at suggest we could even get a bit more core goods weakness over the next 3-6 months. And is there any reason to expect the dollar's strength to reverse? The dollar is the best house in a bad neighborhood, as it is said…for now. So I am no longer so confident that the greenback will start weakening soon.
Moreover, I am also less sure that interest rates are going to rise in the near term. While the Fed has begun to raise short-term interest rates, the economy is evidently weakening and the stock market isn't doing very well recently to put it mildly. A further hike of rates this month is virtually out of the question, and further hikes this year are hardly assured. While higher inflation this year should cause nominal rates to eventually leak higher, I am not sure how soon that will happen. And if it doesn't happen, then money velocity will probably not rise substantially. If velocity merely flatlines, then 5%-6% money supply growth with 2% GDP growth gives you 3%-4% inflation, which is still fairly perky compared with what most analysts are currently expecting but hardly alarming in the big picture.
The big picture concern - which is merely held in abeyance, since money velocity cannot stay permanently low unless interest rates also stay permanently low - is that interest rates and velocity must eventually return to some semblance of normalcy, if the economy is to be considered back in normalcy, and unless the Fed removes all of the excess reserves so that it is able to then start to shrink the money supply, rising velocity in the context of 5%-6% money supply growth produces pretty ugly inflation outcomes. (Go to our monetary inflation calculator to see what can happen with even a modest rebound in velocity.)