We have been suggesting for some time, in previous articles at Seeking Alpha, that Core CPI will become an issue going into Q3 2018. So, we are not surprised that Core CPI is suddenly back in the limelight. Sharp gains over the past several months refocused the market's attention to this very lagged variable which, if you properly think about it, does not deserve the attention of the market, much less the Federal Reserve. Why? Because Core CPI (or even Core PCE, for that matter) is nothing but a "residue" of GDP growth, in the same way that the exhaust smoke of a car is a residue of the internal combustion that is powering the car.
To extend the analogy further, the greater the output generated by the combustion engine, the greater the exhaust smoke at the end - there is a distinct proportionality in the relationship of the output and the residue. That holds true for GDP growth and Core CPI (even for Core PCE) - the higher the GDP growth, the higher the resultant core inflation. Simply put, inflation is a function of GDP growth.
It is therefore a mystery to us why the Fed chose to couch its monetary policy in terms of controlling inflation. An even bigger mystery is why the Fed's policy response to GDP growth and Core CPI lags so far behind both variables (see graph above). You do not see this kind of dissonance in the reaction function of other global central banks to inflation (the European Central Bank, for instance).
This leads us to believe that core inflation has no real significance to the Fed (or more properly, there should not be). Why? The variable lags so far behind GDP growth (which is the prime generator of inflation) that core inflation is virtually worthless as a macro data (except as input in bond valuations). If the Fed is not aware of this, then it's a pretty dumb Fed. But they are not dumb - they just have other agenda, and they know what they are doing. Let's explore that in a later part of this article.
Some background info on inflation
There is a unique link between the change rate of core inflation and GDP change rate in the US, as can be obtained since 1950 (the earliest data available to me). Properly defined, core inflation is a linear and lagged function of GDP growth change rate - therefore, GDP growth rate is a valid predictor of core inflation. As we are interested in using GDP growth as a predictor of inflation, we use GDP growth rates (both year on year and quarter on quarter) in order to match the dimensions of core inflation (also yoy and qoq).
There are certain issues which we will ignore in this study; for instance, both variables are non-stationary, so the validity of regression results could be under doubt. But as we are merely illustrating the relationships between growth, core inflation and corresponding Federal Reserve monetary policy, we dispense with statistical proofs. Consequently, in the studies which we have undertaken for this article, we treated the links between GDP and core inflation as "mechanical," so that any change in the defining parameters of GDP is always fully transmitted into a strictly proportional change in core inflation.
Fed policies, GDP growth and Core inflation rate in the past 50 years
There is a distinct cadence in the relationship between GDP growth, core inflation and the subsequent and corresponding reaction function of the Federal Reserve. This is the timeline: GDP change rates lead changes in core inflation by 5-6 quarters. Core CPI, in turn, leads changes in the Fed Funds Rate (proxy of Fed policy changes) by 2 quarters. Read that again and refer to the graph above.
The very lagged response of core inflation to growth is what gives rise to one of the least understood economic phenomena - stagflation. This economic equivalent of a lose-lose situation happens because the lagged response of core inflation does not correspond to the general business cycle (see graph below). That is exacerbated further by the very late reaction function of the Federal Reserve to the changes in growth and changes in core inflation. The relationships among these three variables are circular, but they are not non-linear.
How stagflations occur, and why
Stagflation arises when GDP growth starts falling, but the lagged response of core inflation from the previous up cycle is still rising. An example of a period when stagflation is rampant is shown in the boxed portion of the graph shown above. Stagflations are not creations of economic policies, per se - these periods are the delayed manifestation of the "residue" of the economic combustion engine as it travels to the back of the car. These periods are baked in the GDP cake as well, and anyone with an understanding of the sequence and timeline of growth, core inflation, and Fed policy changes will be able to predict future stagflationary periods easily, well ahead of time - as long as 5-6 quarters into the future (see graph below).
Not to be left unsaid, knowledge of those dynamics enables anyone to predict the path (and to some degree, the extent) of core inflation changes 5-6 quarters ahead (see graph below).
What the graph above suggests is that the year-on-year Core CPI will be rising well beyond September this year and into Q3 2019, in fact. The quarterly Core CPI, however, will tend to decline over the next 4-5 months.
The graph above also suggests that if GDP growth peaks in Q3 or Q4 2018, as we expect and have discussed elsewhere, then we will see stagflation from Q1 to Q3 2019. We will see falling growth and rising core inflation - interesting dynamics for the bond market and for commodities, which are both linked to inflation.
Commodities should perform particularly well during stagflation periods, due to the coupling of this asset class to inflation. Commodities are generally linked to GDP, but the changes in this asset class lag behind changes in growth by 4-5 quarters. Hence, it shares the same periodic signature with inflation, but Commodities lead Core CPI slightly (by 1-2 quarters). We are convinced that commodities provide the transmission mechanism of the causality which begins with GDP growth and ends up in Core CPI approximately one a half years later.
And as we also said before, it does not need extraordinary obtuseness in monetary and fiscal policy to make this happen – it just happens due to the dynamics of the vectors in the mix. The variances in the lagged response of inflation to changes in GDP growth, and the lagged monetary response to those developments, make stagflation inevitable, even if known beforehand.
The Fed's focus on inflation is a sham
Inflation is a natural offshoot of GDP growth, and as we said, "baked in the cake." Therefore, it's really no big deal, whether or not the Fed allows core inflation to stay or rise beyond their 2% "line in the sand". Inflation will inevitably decline at some point in time after GDP growth has already fallen (due to tighter monetary policy) and after the FFR has already started easing off (due to the Fed's easing response to falling GDP). The graph below shows how that dynamic works:
Simply put, all the Fed's focus on core inflation is a sham and masks the fact that what the Fed is actually regulating is GDP growth. Think about it - how can you ameliorate (with policy rates) the effect (core inflation)? You try to regulate the cause (growth). But they could not say so in those terms - they will be flayed alive if they say they are raising rates because they fear higher GDP growth rates. They have to use inflation as the bogeyman.
The Fed has not been very concerned about Main Street, which will lose jobs if they engineer a recession by over-tightening - which they have consistently done in the past, and they will continue doing so in the future. There is that Fed academic arrogance which revels in the fact that they have the wherewithal to make the claim of having "mastered" inflation (after inflation came down). Hence, they will try to "control" inflation at any cost (inevitably, via a recession). And of course, showing that they are doing "something" perpetuates the need for the Fed as "regulator" of the economy - and of the commercial banks.
Some questions remain: if "controlling" inflation is a major remit of the Fed (the one that is most relevant to their policymaking), how hard can that be to regulate something that tends to be "baked in the cake"? Making core inflation come down is an easy thing to do. Anyone can do it. Just engineer a recession by raising rates hard, and core inflation will come crashing down 5-6 quarters after GDP has collapsed.
Understanding that Core CPI lags behind GDP growth, we know that inflation will be rising over the course of summer - and knowing that provides solid cues into some investment ideas. For instance, rising Core CPI into August-September provides support for our thesis that commodities will be ascendant into Q3 2018. For that matter, the long lead of GDP growth also implies that commodities will be performing well into Q3 2019 (at least on a relative basis versus equities). This supports our other thesis that commodities will start outperforming equities soon, maybe as soon as Q3 this year.
There are other ideas in the shorter term. The CPI report will be published on May 10, Thursday, this week. Based on our work, we expect Core CPI year on year to rise, likely to 2.2%-plus, and maybe even rounded up to 2.3%. The median CPI could rise above 2.5%, close to 9-year highs. However, Core CPI quarter to quarter may start falling, following the quarter-to-quarter changes in GDP.
This behavior, if it happens, is consistent with our outlook that the quarter-on-quarter Core CPI peaked last month (see graph below) and will continue to fall over the next 3-4 months. On the other hand, the year-on-year Core CPI may sort of pause during August-September, but we are not too sure of that, and it does not matter if it doesn't. What we know is that the GDP yearly growth rate has been steadily higher in the past three years. Therefore, the year-on-year Core CPI should progress steadily higher until Q3 2019.
How financial assets respond to Core CPI
Financial assets respond to core inflation in various ways. Some assets respond well to year-on-year inflation Core CPI percentages; other assets respond well to quarter-to-quarter Core CPI changes.
The most interesting relationships can be found between Core CPI versus US Dollars TWI, and Core CPI versus Gold. The two graphs below will show these interesting relationships:
A rise in Core CPI (yoy) is negative for the US Dollar (yoy)
However, in the longer run, the y-o-y US dollar change rate tends to follow the path of q-o-q core inflation. There could be a negative response to the rise in y-o-y Core, but as the quarterly Core continues to decline over the following months, it should start supporting the rise of the US dollar.
A rise in Core CPI (yoy) should be positive for Gold (yoy)
In the longer run, the y-o-y gold change rate tends to follow the path of y-o-y core inflation. There should be a positive gold response to the rise in y-o-y Core.
There is no mystery to Core CPI. The real mystery lies in the Fed's very lagged reaction function to changes in growth and in developments taking place in the US Core CPI. It is also puzzling why the Fed and other central banks try to "control" inflation (the effect) and not GDP growth (the cause). Perhaps it is really growth that they are targeting, not allowing strong growth to take place because of fear that the resultant Core CPI will exceed the lines that they have drawn in the sand (e.g., 2%).
However, the Fed's curtailment of growth (for fear of the resultant inflation) since after World War II has always resulted in economic recessions and lost jobs for millions of workers. There is something morally repugnant in that power to pursue academic aims but make people lose livelihoods in the process. There must to be other ways to make the Fed's work relevant to the dynamics of the economy without putting millions of people out of work.
More actionable investment ideas based on this article have been earlier presented to, and discussed with, members of the PAM investment community. We invite readers to join us.
Disclosure: I am/we are long CLR, EOG, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The PAM portfolio is long gold and short crude oil. The investments of R Balan in E&Ps are being hedged.