Growing Inflationary Pressures Force Even the Swiss National Bank to Hike Rates

The financial world last saw the Swiss National Bank (SNB) hike its interest rate back in 2007. It took “signs of inflation also spreading to goods and services that are not directly affected by the war in Ukraine and the consequences of the pandemic” to force the SNB’s hand (from the Introductory remarks by Thomas Jordan, head of the SNB). The rate move from -0.25% to -0.75% took financial markets by surprise and sent the Swiss franc soaring. USD/CHF declined 2.8% on the day in a move that may have created a double top.

The SNB insisted that “the tighter monetary policy is aimed at preventing inflation from
spreading more broadly to goods and services in Switzerland.” While the SNB also warned that these inflationary pressures may force the SNB to increase rates further, its current forecast for inflation at the -0.25% rate is for inflation to return to the 2% target starting next year. Note the significant increase in the inflation forecast since March (the red line over the yellow line).

The fast transmission of price increases also caught the SNB’s concern: “…price
increases are being passed on more quickly – and are also being more readily accepted – than
was the case until recently.” This acceptance is one of the drivers of higher inflation expectations that can lead to stubbornly high inflation. Moreover, second order inflation effects are threatening the inflation outlook. Interestingly, weakness in the Swiss franc is suddenly working against the SNB’s attempts to avoid deflation: “the Swiss franc has depreciated in trade-weighted terms, despite the higher inflation abroad. Thus the inflation imported from abroad into Switzerland has increased.” This comment makes me much less inclined to short the Swiss franc going forward.

In other words, the Swiss economy has been hit from all angles with price-related shocks. Content to keep rates at -0.25% for so many years, the SNB had to respond with a rate hike. With another 50 basis point hike on the table, the SNB has joined a growing chorus of central banks scrambling to normalize monetary policy. The race to the bottom of devaluation suddenly reversed this year.

Be careful out there!


Persistently Elevated, Unactionable Inflation

Bonawyn Eison, CNBC Fast Money commentator, used the phrase “persistently elevated, unactionable inflation” to describe the current inflationary cycle. Ahead of the disappointing report on May inflation, Eison pushed back on the “peak inflation” narrative as part of an attempt to “reverse engineer” a reason to buy the stock market. While he framed the desperate gaze over the inflation horizon in stock market terms, his characterization is quite appropriate for today’s overall inflation problem. Inflation has been persistent thanks to a powerful convergence of massive monetary stimulus, equally potent fiscal stimulus, and a host of economic disruptions. In turn, inflation promises to remain elevated for quite some time. Perhaps most importantly, the tools for fighting inflation are small compared to the size and the near intractability of the problem. For the Federal Reserve in particular the path to fighting inflation is fraught with the economic perils of stagflation.

The lure of the “peak inflation” narrative has been strong since the report on March inflation. The appeal is natural because of the sense that over time all economic conditions revert to the mean (or the average). However, the rush to declare the end of today’s problem with inflation has been particularly meaningful because it occurs in the middle of a desperate, global desire to return to some form of the “normalcy” we (think) we enjoyed before the pandemic. To their credit, various Federal Reserve members tried to soft pedal the idea of peak inflation, including the San Francisco President back in late April. They have remained nearly uniform in their stated resolve to focus on fighting inflation. The path from 8.6% to anything close to the Fed’s comfort zone does not start with hoping for a peak in inflation.

That 8.6% is where the headline Consumer Price Index (CPI) hit in May. Inflation hurtled March’s 8.5% for a new high for this inflationary cycle. The “peak inflation” crowd might now think surely inflation cannot go any higher from here. Perhaps this hope works out this time, but it matters little in the face of persistent and elevated inflation. Moreover, on the same Fast Money episode featuring Eison’s commentary, Lindsey Piegza, chief economist at Stifel, made an excellent point about the lagging nature of the CPI. Piegza pointed out that the worst impacts of the Russian invasion of Ukraine and the COVID lockdowns in China have yet to hit the CPI. If so, CPI may not continue to increase, but inflation will remain high for quite some time.

The broad-based nature of the May CPI increases suggests that inflation will indeed remain far above the Fed’s comfort zone for quite some time. Both the month-over-month and, of course, year-over-year inflation numbers were elevated across major categories (numbers are monthly and then year-over-year):

  • Food: 1.0% and 8.6%
  • Energy: 3.9% and 34.6%
  • All items less food and energy: 0.6% and 6.0%
  • New vehicles: 1.0% and 12.6%
  • Used cars: 1.8% and 16.0%
  • Shelter: 0.6% and 5.5%

The persistent rise in shelter costs is particularly notable given the Fed’s sudden sense of urgency on normalizing monetary policy implicitly came from housing costs.

I see at least one lesson from these numbers: inflation will not peak until it peaks. In other words, there is little point in straining the eyes over the horizon seeking the end of this inflationary cycle. Whatever the specific numbers, inflation here in the U.S. and across many nations promises to be persistent and elevated and will frustrate the economic agent who try to act against it without causing other economic fallout.

Be careful out there!


SF Fed President Maps the Path Toward Neutral Policy, Not Banking On “Peak Inflation”

More hawkish, anti-inflation commentary from Fed Chair Jerome Powell got top billing today in financial markets. While Powell said nothing new or surprising, he got the blame for a downdraft in stock markets. However, the head of the San Francisco Federal Reserve caught more attention for Inflation Watch. In a great scoop for Yahoo Finance, San Francisco Fed President Mary Daly gave a 15-minute interview discussing her stance on monetary policy. Daly crisply aligned with the new hawkish mood on the Fed. At the same time, she provided clear guidance on the Fed’s objectives and assessments of the current inflationary economy. I recommend watching the video embedded in the article. Otherwise, here are the key highlights and take-aways as you get ready for the May Fed meeting.

  • “The Fed is expeditiously marching towards neutral. It is clear the economy doesn’t need the accommodation that we’re providing” – notice the recognition that current policy is over-stimulative. Maintaining an easy money policy while the economy is strong is not only bad policy, but also doing so increases inflation risks.
  • “The neutral rate is about 2.5% by the end of the year” – this statement sets the stage for several 50 basis point rate hikes this year given rates are still at a paltry 0.25%-0.50%.
  • “We don’t want to go so quickly or so abruptly that we surprise Americans and make them have to adjust quickly…” – the Fed never likes to create downside surprises, only upside ones. Indeed, Daly observed that tightening financial conditions are already tapping on the economy’s brakes. She pointed to mortgage rates as a prime example; a notable reference given a hot housing market is at the center of the Fed’s concerns.
  • Daly insisted that the Fed can pull off a soft-landing.
  • Daly cautioned that predicting “peak inflation” is “fraught with peril” given on-going COVID shutdowns in China and Russia’s invasion of Ukraine.
  • “High inflation is as bad for workers as not having a job” – in other words, the Fed cannot afford to allow inflation to erode spending power on a sustained basis.
  • The Fed funds rate is more precise than and better known for moving monetary policy.

Compare Daly’s comments to this key quote from Powell today:

“It may be that the actual [inflation] peak was in March, but we don’t know that, so we’re not going to count on it…We’re really going to be raising rates and getting expeditiously to levels that are more neutral and then that are actually tight … if that turns out to be appropriate once we get there.”

The Fed is all-aboard the anti-inflation locomotive!


Jim Bianco: “Arguably One of the Worst Forecasts In Fed History”

I thought *I* was critical of the Fed waiting so long to start normalizing monetary policy! Jim Bianco, President of Bianco Research, LLC, took criticism of the now moribund “transitory inflation” narrative to a new extreme. In an interview with CNBC’s Fast Money, Bianco took the Fed to task for what he called “arguably one of the worst forecasts in Federal Reserve history.” As a result, the Fed finds itself stuck with an inappropriately loose monetary in the middle of a high price, supply-constrained economy. The Fed intends to dampen demand through higher borrowing costs and lower stock prices (the wealth effect). The historic gap between job openings and the number of unemployed gives the Fed plenty of room to hike rates (until something breaks).

Fast Money invited Bianco after noticing an extended twitter thread that also took the stock market to task for ignoring rate hike risks. Bianco noted the dichotomy between a bond market that understands the Fed is more focused on controlling prices than growth, and a stock market that keeps doing its best to ignore the prospects. Bianco’s charts show that “the carnage is epic” in the bond market: “This is not only the worst bond market in our career (total return) but might be the worst of our lifetime.” Meanwhile, Bianco insists that what is ahead will hurt all financial assets.

The Trade

In “The Market Breadth“, I specialize in market opportunities at the extremes of behavior. So hearing that the bond market is suffering historic losses actually intrigues me. I suspect that sometime in the middle of an aggressive tightening cycle, bonds will present a generational buying opportunity. I am not a student of bond markets, so I will have to rely on the technical signals from a proxy bond instrument like the iShares 20+ Year Treasury Bond ETF (TLT). The weekly chart below suggests that the opportunity zone on TLT sits somewhere between the 2013 lows (government shutdown drama) and the lows of the financial crisis. I assume the lows of 2018 will be an insufficient stopping point, but I will watch closely for a bounce at that level. On the way down, I have been fading TLT rallies with put options.

The iShares 20+ Year Treasury Bond ETF (TLT) is in a bear market with a 26% drawdown from its all-time high during the stock market crash of March, 2020.

Be careful out there!

Full disclosure: no positions


Low Wage Pressures Suppressing Inflation In Australia

Earlier this week the Reserve Bank of Australia (RBA) released its latest decision on monetary policy. I was surprised to read that inflation remains relatively low in Australia compared to other industrialized countries. From the RBA:

“Inflation has increased in Australia, but it remains lower than in many other countries; in underlying terms, inflation is 2.6 per cent and in headline terms it is 3.5 per cent.”

Seeing that data, I wondered whether the soaring prices of commodity exports and the resulting stronger Australian dollar are helping tamp down inflation. The RBA mentioned neither of these potential drivers. Instead, the central bank fingered low wage pressures:

“Wages growth has picked up, but, at the aggregate level, is only around the relatively low rates prevailing before the pandemic…Inflation has picked up and a further increase is expected, but growth in labour costs has been below rates that are likely to be consistent with inflation being sustainably at target. “

This sluggish wage growth is giving the RBA the luxury of standing still on monetary policy. The statement gave no hint of a specific time horizon for tightening rates. The RBA is waiting for “…evidence that inflation is sustainably within the 2 to 3 per cent target range before it increases interest rates.” In other words, wage growth is so slow that there are risks to the downside for inflation.

The Australian dollar reacted well in advance of and following the statement. A larger sell-off in financial markets the next two days reversed all the gains for AUD/USD.

The Australian dollar vs the U.S. dollar (AUD/USD) is pulling back in the face of hawkish minutes from the U.S. Federal Reserve.
The Australian dollar vs the U.S. dollar (AUD/USD) is pulling back in the face of hawkish minutes from the U.S. Federal Reserve.

Be careful out there!
Full disclosure: short AUD/USD


The Federal Reserve Fears On-Going Inflationary Pressures from Rents

I recently complained about the Fed’s belated sense of urgency in trying to get inflation under control. The Federal Reserve Bank of St. Louis shed some light on the specific points of concern for the Federal Reserve. In an economic article titled “Breaking Down the Contributors to High Inflation“, the St. Louis Fed described a 12-month lag for housing price dynamics to feed into rents. Given the soaring prices of housing for over a year, rents are due to soar from already high levels for at least the next year or so. Here is the instructive chart:

The Fed’s core concern comes from the out-sized influence of housing services on the PCE (Personal Consumption Expenditures): “Given that housing services constitutes the largest subcomponent of PCE, accounting for roughly 18% of total consumption expenditures, the impact of housing services inflation on overall PCE inflation is always significant.” In other words, I interpret the Fed’s recent religion on normalizing interest policy as a belated attempt to cool down price appreciation in the housing market.

The St. Louis Fed also put this concern in context by comparing today’s inflation with the inflation from the last economic expansion from July 2010 to January 2020. Interestingly each of the three components of the PCE – durable goods, non-durable goods, and services – have contributed around the same amount of extra inflationary pressure in absolute terms, ranging from 1.46 to 1.71 percentage points. However, with a 65% of total consumption expenditures, the promise of on-going upward pressure on services inflation promises to drive the overall PCE ever higher. The Fed finally could no longer sit still on rates.

(For a good read on belated inflation concerns, review Jason Furman’s critique of the economics profession: “Why Did Almost Nobody See Inflation Coming?“)

Be careful out there!

Full disclosure: no positions


An Attempt to Explain Today’s Lower Inflationary Pressures In Japan

In a world of soaring commodity prices, major commodity importers should worry about increasing inflation risks. Japan is the world’s fifth largest importer with at least its top 5 imports consisting of commodities: crude oil, coal briquettes, petroleum gas, refined petroleum, and iron ore. Yet, the Bank of Japan is not much worried about inflation risks. In an important speech on March 29, 2022 AMAMIYA Masayoshi, the Deputy Governor of the Bank of Japan, described inflation as a problem for the U.S. and Europe but not for Japan. In “The COVID-19 Crisis and Inflation Dynamics: Opening Remarks at the Workshop on ‘Issues Surrounding Price Developments during the COVID-19 Pandemic‘, Masayoshi offered several explanations for Japan’s lower modest 2% increase for its consumer price index (CPI):

  • Japan experienced a limited shift in demand. In the U.S. in particular, a sharp shift from services to goods consumption created severe supply shortages which in turn helped drive up prices.
  • A strong risk aversion in Japan limited pent-up demand for private consumption. As a result, Japan did not experience disruptive shifts in demand. Japanese conservatism has also anchored labor mobility, a key ingredient for the kind of wage pressures that can contribute to inflation.
  • The waning of the pandemic has revived the Japanese corporate “norm” of deflationary thinking – the “assumption that prices will not increase easily.” Accordingly, unlike U.S. firms, Japanese firms prefer to focus on long-term business relationships and are reluctant to increase prices. According to Masayoshi, “When there are supply-side constraints for certain goods, U.S. firms tend to raise prices relatively quickly and allocate goods by giving preference to customers who are willing to pay higher prices. In contrast, Japanese firms seem to place more emphasis on long-term business relationships with customers and respond to their demand as much as possible while keeping selling prices unchanged.”
  • Service prices remain relatively weaker in Japan (although Masayoshi called on a review of statistical practices).

Masayoshi concluded with the claim that “our understanding of inflation remains limited.” Despite this purported limited understanding, the Bank of Japan is quite confident enough to buy an unlimited amount of bonds to defend its ultra-low interest rates. Last week the BoJ surprised financial markets with this vigorous defense of its zero interest rate policy (ZIRP). The immediate reaction in the currency market sent an already rapidly weakening yen even lower. The rush to sell more yen created a (likely temporary) exhaustion of sellers. The yen rebounded for three days before selling resumed on Friday.

A divergence in monetary policy is helping to grease the skids for the yen. Last week, the Invesco CurrencyShares Japanese Yen Trust (FXY) plunged to an all-time low (since 2007).

As long as a differential in inflationary expectations exists between Japan and the U.S., the downward pressure on the yen should also persist.

Be careful out there!

Full disclosure: long FXY put options


Transitory Complete: Fed Chair Jay Powell Gets Comfortable With the Inflation Hawks

Transitory Complete

Pandemic-era inflation pressures were not transitory after all. The inflation watchers I follow never believed the narrative given the Fed’s insistence on maintaining historically accommodative policy well past its expiration date. Indeed, the transitory in the economy turned out to be the deflationary psychology of Federal Reserve Chair Jerome Powell.

The journey has been quite a ride for Fed-speak. In July 2020, Powell reassured an economy in lockdown shock that the Fed is “not thinking about thinking about raising rates.” When murmurs and then gripes about creeping inflation emerged in early 2021, Powell insisted inflation pressures would be transitory. In late April of that year, Powell explained the theory at that time behind transitory inflation. Transitory stretched out longer and longer and longer, until finally in December, 2021 testimony Powell essentially asked everyone to leave him alone about the unfortunate and untimely phrase. Now, with inflationary pressures worsening, Powell has found inflationista fervor. Powell even declared that the Fed is ready to take rates higher than the neutral rate. The mad scramble has begun; the Fed wants to get a raging fire under control.

A Pivotal Speech

Today, March 21, 2022, Powell gave what I think is the pivotal speech of his career as Fed chair. With the appropriately ominous title “Restoring Price Stability“, Powell started with this proclamation to the 38th Annual Economic Policy Conference National Association for Business Economics assembled in Washington, D.C. (emphasis mine):

“…the current picture is plain to see: The labor market is very strong, and inflation is much too high. My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability. We are committed to restoring price stability while preserving a strong labor market.”

For the folks who might still be in transitory thinking, Powell went on to clarify “…the inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine.”

In racing against the wildfire, Powell and the Fed have an ambitious goal. They want to avoid a recession by tapping the brakes on excessive demand in the economy just enough to gently match limited supply. The strong labor market is both a blessing and a curse in this effort. Powell did not use the term “wage-price spiral” inflation spiral”, but he essentially described such a potential dynamic for today’s economy. Companies are struggling to hire. Employees are shifting into new jobs to gain higher wages.

“There are far more job openings going unfilled today than before the pandemic, despite today’s unemployment rate being higher. Indeed, there are a record 1.7 posted job openings for each person who is looking for work. Record numbers of people are quitting jobs each month, typically to take another job with higher pay. And nominal wages are rising at the fastest pace in decades, with the gains strongest for those at the lower end of the wage distribution and among production and nonsupervisory workers”

Powell summarized: “Overall, the labor market is strong but showing a clear imbalance of supply and demand.” Thus, the Fed feels compelled to “moderate demand growth.” In the process the Fed hopes that the labor market’s very strength will withstand a period of aggressive monetary tightening.

Powell explained that the big surprise came from the stubborn persistence of “supply-side frictions.” The economy cannot handle the rapacious demand in today’s economy without sending prices ever higher. In turn, spiraling inflation threatens to erode wage gains especially for lower-income workers.

No Time to Wait Anymore

Interestingly, Powell provided automobile prices as a good example of the inflation problem. There was a time when commentators insisted soaring car prices would be transitory. Auto prices are now transitory complete. Powell lamented “production remains below pre-pandemic levels, and an expected sharp decline in prices has been repeatedly postponed.” Prices for new cars soared almost all of last year and suddenly look ready to take off again. Used car prices soared even more and could lift again if new car prices rev up again. Regardless, no “base effects” here as worker’s wage gains look sure to come under more pressure.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUSR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUSR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average [CUSR0000SETA02], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

These mounting pressures have forced the Fed’s hand. The Fed senses it has no time to wait anymore. The Fed is no longer content to wait for the conventional expectations of normalization to bear fruit. In an inflation emergency the Fed needs to act now… (emphasis mine).

“It continues to seem likely that hoped-for supply-side healing will come over time as the world ultimately settles into some new normal, but the timing and scope of that relief are highly uncertain. In the meantime, as we set policy, we will be looking to actual progress on these issues and not assuming significant near-term supply-side relief.”

Inflation is so strong now that Powell has to look out 3 years to envision inflation returning to the Fed’s target of 2%: “I believe that these policy actions and those to come will help bring inflation down near 2 percent over the next 3 years.”

Recession? What Recession?

No Federal Reserve has ever predicted a recession. The central agent trying to command the economy has a vested interest in projecting utmost confidence in its navigation abilities. Accordingly, Powell looked to history as proof that the Fed can pull off the spectacle of the soft landing for the economy:

“I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession…In other cases, recessions chronologically followed the conclusion of a tightening cycle, but the recessions were not apparently due to excessive tightening of monetary policy. For example, the tightening from 2015 to 2019 was followed by the pandemic-induced recession.”

The Fed is also encouraged by an economy “well positioned to handle tighter monetary policy.”

Powell formerly insisted the Fed would hold rates lower for longer in order to achieve an exceptionally low unemployment rate. The current path flips to the opposite direction. The Fed is willing to go right past the point of neutral rates to get the fire under control: “if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.”

Transitory complete. Bring on the inflation hawks.

Be careful out there!


PPG Industries Warns of Intensifying Inflation Pressures and Weakening Demand

{Originally published on One-Twenty Two by Dr. Duru}

““As we look ahead, we currently do not anticipate any relief from inflationary cost pressures in the third quarter. We expect aggregate global economic growth to remain positive with end-use market activity comparable to the second quarter, adjusted for traditionally lower seasonal demand. However, uncertainties exist regarding global trade policies, which may create uneven demand by region and in certain industries. Specific to PPG, we expect that the previously announced architectural customer assortment change will lower our third quarter year-over-year sales volume growth rate by between 120 and 150 basis points. We remain confident that our leading-edge technologies and products, which are bringing value to our customers, will facilitate our growth going forward….

Currently the new tariffs are starting to add some modest cost to our raw materials. Based on the strength in the US dollar in the second quarter, we expect foreign currency exchange rates to have an unfavorable impact to our sales in the third quarter”

This was the essence of the guidance industrial paint company PPG Industries (PPG) provided in its 2nd quarter earnings report. I added the emphases because the warnings on inflation and international demand were clear precursors to the company’s pre-earnings warning tonight. The stock traded down about 10% in after market trading in response to significant cuts in revenue and earnings guidance. I was most interested in the explanation which made the second quarter’s caution come to life (emphases mine)…

““In the third quarter, we continued to experience significant raw material and elevating logistics cost inflation, including the effects from higher epoxy resin and increasing oil prices…These inflationary impacts increased during the quarter and, as a result, we experienced the highest level of cost inflation since the cycle began two years ago.

“Also, during the quarter, we saw overall demand in China soften, and we experienced weaker automotive refinish sales as several of our U.S. and European customers are carrying high inventory levels due to lower end-use market demand…Finally, the impact from weakening foreign currencies, primarily in emerging regions, has resulted in a year-over-year decrease in income of about $15 million. This lower demand, coupled with the currency effects, was impactful to our year-over-year earnings and is expected to continue for the balance of the year.”

Instead of moderating, inflationary pressures are mounting on PPG. The weakness in China is telling in the context of the trade war with the U.S. The lower “end-use market demand” points to the trickle-down impact of “peak auto.” These warnings are each important given PPG has a market cap of $26.5B and trailing 12-month revenue of $15.4B. I fully expect other industrial companies to deliver similar news this earnings season.

Interestingly, Credit Suisse downgraded the stock in late September and the market responded by taking PPG down 2.8% on relatively high trading volume. The gap down confirmed the end of PPG’s post-earnings run and breakout above 200-day moving average (DMA) resistance. Until the downgrade the stock finally looked ready to challenge its 2018 high.

PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.
PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.

Source: FreeStockCharts.comThe market is supposed to be a forward-looking mechanism, so it is natural to wonder why PPG was rallying so well in the first place. I do not put all the blame on investors. I assume the company itself was partially responsible through its sizable share repurchase program. For the first half of 2018, PPG spent $1.1B on its own shares: 4.1% of the company’s current market capitalization. With this kind of aggressiveness, PPG should quickly move in on the new 52-week low to add to take out even more shares.

As earnings season unfolds, I will be paying close attention to company commentary on trade woes and inflation. The stock market has spent most of the past several months ignoring risks, so there are a good group of over-priced stocks out there waiting their turn for a douse of realty. Collectively, these warnings could be the catalyst that delivers the oversold market conditions I am anticipating.

Full disclosure: no positions


Acuity Brands: Wage and Tariff Inflation and Resulting Business Uncertainties

(Originally published on One-Twenty Two by Dr. Duru)

I last mentioned Acuity Brands (AYI), a lighting and building management solutions company with $3.7B in net sales in 2018, three months ago. At that time, I described a good risk/reward setup to go long the stock post-earnings. AYI shot nearly straight up from there. The stock broke through resistance at its 200-day moving average (DMA) and gained as much as 34.7% before peaking intraday in September. While I only participated in a portion of that run-up, I am glad I did not overstay my welcome. Fast forward to last week: AYI suffered a massive post-earnings gap down. The stock lost 16.3% and sliced right through 200DMA support after the 50DMA gap down. Sellers closed the week confirming the bearish breakdown. AYI has now almost erased its entire incremental gain from July earnings.

Acuity Brands (AYI) looks set to reverse all its previous post-earnings gains after a disastrous earnings report that sent the stock crashing through its 50 and 200DMAs
Acuity Brands (AYI) looks set to reverse all its previous post-earnings gains after a disastrous earnings report that sent the stock crashing through its 50 and 200DMAs

Source: FreeStockCharts.com 

This moment is critical for the stock. AYI hit an all-time high in August, 2016 and sold off pretty steadily from there (on a monthly basis) until reaching a 4-year low in May, 2018. If AYI completes a full reversal of its gains from July earnings, then the stock greatly increases its risk of resuming the downtrend from the all-time high.

AYI’s earnings report was interesting for a lot more than the technical disaster. The company also delivered some telling remarks about today’s inflationary environment. The company begain its conference call by launching right into the bad news. From the Seeking Alpha transcript:

“While our results for the fourth quarter and the full year were records, we had higher expectations coming into 2018. Market conditions for growth were far more subdued than most had originally anticipated, especially for larger commercial projects and deflationary pricing persisted throughout the year, while cost pressures were far more significant than most had forecast, particularly in the fourth quarter.”

The general market environment hindered the business:

“Based on the information from various data collection and forecasting organizations, we believe the overall growth rate for the fourth quarter as measured in dollars for lighting in North America was flat to slightly down, continuing the sluggish trend over the last several quarters…

We believe the lighting industry will continue to lag the overall growth rate of the construction market, primarily due to continued product substitution to lower priced alternatives for certain products sold through certain channels.”

For the fourth quarter and full-year, the company sported record revenues and diluted earnings but significantly lower operating profit and margin. The cost pressures came from multiple inflationary fronts including tariffs and wages. Emphasis mine…

“Another significant factor impacting our adjusted gross profit and margin was higher input cost for certain items, including electronic and certain oil-based components, freight and certain commodity-related items, particularly for steel. Many of these items experienced dramatic increases in price in the fourth quarter due to several economic factors including enacted tariffs and wage inflation due to the tight labor markets.

We estimate the inflationary impact of these items reduced our adjusted gross profit in the quarter by more than $20 million, lowering our adjusted gross profit margin by 200 basis points and reduced adjusted earnings per share this quarter by $0.38…

…we expect employee-related costs will continue to rise as we enter fiscal 2019 as markets for certain skills remain tight contributing to a rise in wage inflation…”

AYI also explained that it sources from China about 15% of its components and finished goods which are subject to the new import tariffs.

Freight costs are an increasing burden. The combination of rising oil prices and the rising wages that come from a severe shortage of truck drivers are driving freight rates skyward. Shipping a lower-value product mix is exacerbating the shipping burdens.

As we would expect, AYI is scrambling to mitigate these costs by finding alternative suppliers and production sources, improving productivity, and increasing prices. The company announced price hikes last month and new price increases go into effect on October 15th. Assuming the new 25% bump in tariffs on Chinese imports goes into effect on January 1, 2019, AYI will raise prices yet again. IF AYI makes these price hikes stick without losing much demand, then the stock could represent a great buying opportunity. Better margin numbers should start appearing by the second fiscal quarter 2019.

AYI cautioned that a lot uncertainty surrounds the potential impact of the cost pressures. For example, the inflationary pressures from tariffs caught the general industry by surprise as participants have experienced a deflationary environment for a “handful of years.” The demand impacts are hard to assess: “It is not possible for us to precisely determine what the potential impact tariffs will have on demand as it is a very complex situation impacted by numerous factors including currency fluctuations and political outcomes.”

As the inflationary adjustments unfold, I will watch the technicals for signs of renewed buying interest. The company itself is one source of buying. AYI repurchased 2M shares at a cost of $298.4M in its fiscal year 2018. AYI still has 5.2M shares left under its repurchase authorization. I have to assume the company will aggressively buy shares in the coming months given the current stock price of $130.99/share is well below the average cost basis of $149.20/share of the to-date repurchased shares.

Finally, it is possible tariffs could HELP AYI although the company did not specifically say so. In the conference call AYI pointed out that the Chinese government is subsidizing lighting companies who are undercutting price for lower-value fixtures. This competitive pressure is important because, as noted earlier, some of AYI’s customers are downshifting to these lower-valued products. AYI is determined to compete – “We will not yield this space for many strategic reasons” – and this competition represents one more important risk factor for the business.

Overall, AYI is one more cautionary tale about the unanticipated impacts of today’s new inflationary environment. Given that financial markets are generally ignoring most potential fallouts from the expanding trade war between the U.S. and China, this earnings season should deliver many more surprises like AYI’s.

Be careful out there!

Full disclosure: no positions


Inflation Washes Ashore

Ever since the election of Donald Trump as U.S. President, the stock market has gone into a “Trumpflation” mode of trade. The early evidence of inflation may have finally washed ashore.

U.S. January prices rose 0.6% and core prices rose 0.3% month-over-month. Both were slightly higher than expected, and the rise was the highest since February, 2013. Year-over-year the Consumer Price Index (CPI) rose 2.5%, the highest since march, 2012. The CPI incorporated some particularly strong price hikes:

“Clothing prices jumped 1.4 percent, the most since February 2009. Men’s apparel surged by the most on record. New vehicle prices climbed 0.9 percent in January, the biggest advance since November 2009.”

The price hikes were enough to push real hourly wages down by 0.5% form December and unchanged year-over-year.

This is just one month of data, yet it precedes any of the policy changes or fiscal stimulus measures which promise to introduce inflationary pressures into the U.S. economy. InflationWatch is officially back on alert for the U.S.!

https://www.bloomberg.com/api/embed/iframe?id=f020e8cd-257d-4519-85a0-ddbdd3bf1339


On the Ground Measuring Inflation

Ever wondered exactly how the government measures inflation via individual products? Planet Money ran a segment explaining the process in 2010 that was rebroadcast last year. I caught “The Price Of Lettuce In Brooklyn” sometime early last year. I was absolutely amazed to learn that the government actually sends surveyors into the field to sample prices from various stores on very specific goods. The surveyors have to exercise particular care to measure prices for the exact same goods over time. That basket of goods is then aggregated across products and locations into what we know as the Consumer Price Index (CPI).

I highly recommend this 15-minute podcast for anyone who wants an introduction to inflation monitoring at the ground level.

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Source: NPR Planet Money


Cross-Post: The Canadian Dollar’s Rapid Devaluation Presents An Inflation Predicament for the Bank of Canada

(This is a cross-post from my blog One-Twenty Two)

A year ago, the Bank of Canada (BOC) delivered the first of two rate cut surprises for the year. So with oil still cratering ever lower, I can understand why the market seemed braced for yet another rate cut last week. Instead, the BOC not only stood still on rates, but also it expressed an implied reluctance to reduce rates any further unless absolutely necessary. The result was an immediate jump in the Canadian dollar (FXC) featuring a drop in USD/CAD. USD/CAD continued to sell off right into the week’s close.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.


Source: Oanda’s CFTC’s Commitments of Traders

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.


Source: FreeStockCharts.com

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.


Source: Board of Governors of the Federal Reserve System (US), Canada / U.S. Foreign Exchange Rate [DEXCAUS], retrieved from FRED, Federal Reserve Bank of St. Louis, January 23, 2016.

Here is the key quote from Governor Stephen S. Poloz’s opening statement:

“It is fair to say, therefore, that our deliberations began with a bias toward further monetary easing.”

The on-going collapse in oil and all its destructive consequences for the Canadian economy still justify further easing. BUT…

“First, the Canadian dollar has declined significantly since October, which means that the non-resource sectors of our economy are receiving considerably more stimulus than we projected then. Let’s remember that it typically takes up to two years for the full effect of a lower dollar to be felt.

Second, past exchange rate depreciation is already adding around 1 percentage point to our inflation rate. This is a temporary effect, and is currently being offset by lower fuel prices—another temporary effect. However, we must be mindful of the risk that a further rapid depreciation could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations.”

In other words, financial markets have pounded the Canadian dollar so thoroughly that most of the BOC’s goals for easing have been accomplished already. The potential 2-year lag in impact means that the BOC must proceed with extreme caution when deciding to add more kindling to the raging fire of currency devaluation.

Moreover, this devaluation is now exerting inflationary pressures on the Canadian economy – to the tune of an incremental 1 percentage point. While current inflation may still be within tolerance, the pace of the increase could be strong enough to send future inflation expectations soaring past the BOC’s comfort zone. Given the lagging impact of the devaluation, the BOC could find itself fighting stubbornly high inflation expectations for an uncomfortably long time. During the press conference, Poloz clarified that the BOC does not think this process is underway. The Bank is simply keeping an eye on this potential – which is clearly enough to give them caution about doing anything that further drives down the value of the Canadian dollar.

Given these cautionary caveats, the BOC decided to leave rates just where they are. From the press release:

“The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1/2 per cent. The Bank Rate is correspondingly 3/4 per cent and the deposit rate is 1/4 per cent…

…All things considered, therefore, the risks to the profile for inflation are roughly balanced. Meanwhile, financial vulnerabilities continue to edge higher, as expected. The Bank’s Governing Council judges that the current stance of monetary policy is appropriate, and the target for the overnight rate remains at 1/2 per cent.”

As usual, the BOC is cautiously optimistic about economic prospects. Despite a disappointing 2015, the BOC still expects the global economy to resume “gradual strengthening” in 2016. Expectations incorporate an assumed transition to a 6% annual GDP growth rate for China, and continued “solid” performance from the U.S. Even with weak exports to the U.S. in the fourth quarter, the BOC expects export activity to turn right around in 2016. While downgrading its forecast for Canada’s GDP growth in 2016 to 1.4%, the BOC emphasized that year-over-year, growth should be 1.9% for the fourth quarter of this year.

Even though the BOC did not cut rates in this last meeting, make no mistake about its bias. The BOC thinks it could take up to three years for the Canadian economy to fully adjust to the complex structural changes wrought by the collapse of the oil complex. The Canadian economy may not absorb excess capacity in the economy until late 2017. The BOC also acknowledged the growing magnitude of the shock from this collapse. The BOC called this reality a “significant setback compared with our October projection.” During the press conference, Poloz also admitted that the odds of a recession are higher than they have been in a very long time. All these realities imply a notable bias toward weakness for the Canadian dollar for quite some time.

When I wrote about the Canadian dollar’s fresh milestone of weakness, I described a small counter-trend bet that USD/CAD would return to 1.40. As the chart above shows, the USD/CAD just continued to spring higher after the 1.40 breakout. The Bank of Canada’s stasis on rates combined with the forex response was my signal to finally add to that bet. Without a promise to cut rates again, I fully expect USD/CAD to reverse most if not all of recent gains assuming oil does not resume its rapid plunge in the interim.

I will continue to try holding out for that return to 1.40, but I am perfectly fine bailing on the position if renewed strength shows up ahead of this week’s Federal Reserve’s meeting. On a technical basis, the counter-trend momentum in USD/CAD looks like it could easily retest the uptrending 50-day moving average (DMA). At the current pace, this would happen around 1.39. After I close out this short position, I will be quite eager to get back to trading with the trend.

During the press conference, Poloz would not commit to a specific level past which weakness in the Canadian dollar will no longer help the Canadian economy. He would only say that the assessment depends on the nature of the decline. If the currency is declining “on its own,” then there is a problem. An adjustment from economic realities makes sense – the current decline is mostly about the collapse in the oil complex. However, trends beget trends, and I can see several scenarios of overall financial turmoil and volatility that could send USD/CAD hurtling ever higher even independent of a fresh plunge in oil prices.

So, the Canadian dollar presents a precarious predicament for the Bank of Canada. Its devaluation is a necessary part of the Canadian economy’s adjustment to lower oil prices. The potential inflationary impact of this rapid decline could constrain the Bank’s ability to provide more assistance to a wobbly economy. Yet, without this assistance, the weakness of the economy could drive even more weakness in the currency. Currency traders will easily seize upon the trend above all else.

In coming weeks I will be reviewing the Monetary Policy Report (MPR) and a soon-to-be-released BOC paper on the complex impact of the oil shock to find any additional (tradeable) insights.

Be careful out there!

Full disclosure: long FXC, short USD/CAD


Housing Bubbles: An Ounce of Prevention is Worth a Pound of Cure

Prescription for preventing housing bubbles from the IMF…

iMFdirect - The IMF Blog

By Kevin Fletcher and Peter Kunzel

The main features of boom-bust cycles in housing markets are by now all too familiar.

During booms, conditions such as lax lending standards and low interest rates help drive up house prices and with them mortgage debt.

When the bust arrives, over-indebted households find themselves underwater on their mortgages— owing more than their homes are worth.

Feeling the pinch of reduced wealth and access to credit, households, in turn, rein in consumption. At the same time, lower house prices cause investment in new houses to tumble.

Together, these forces significantly depress output and increase unemployment. Non-performing loans increase, and banks respond by tightening credit and lending standards, further depressing house prices and adding to the vicious cycle.

View original post 753 more words


The Persistence of Deflationist Psychology

Seven and a half years after the financial world as we know it almost completely blew up, deflation remains the biggest fear across the land. Some major central banks across the globe have had to double down on their efforts to fight deflation. For those like me who expected central bank activism to quickly lead to rampant inflation, this world of persistent deflationist psychology is a wonder to behold.

Along this vein comes a fascinating article in the New York Times called “A Prediction Market for Inflation, or Deflation” by Justin Wolfers, a a senior fellow at the Peterson Institute for International Economics and professor of economics and public policy at the University of Michigan. Wolfers warns that the Fed’s focus on hiking rates runs counter to declining expectations for inflation:

“Something unusual is happening to prices right now: They are falling.

The recent sharp decline in gas prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 percent inflation target, hindering the economic recovery. There’s also a small but worrying risk that the economy could enter a deflationary rut.”

Incredulous, I read on….

The majority opinion marginally expects the Fed to miss its 2% inflation target in the next 5 years

Opinion is skewed to a Fed miss of its 2% inflation target in the next 5 years

After seeing this chart, I feel that Wolfers far over-stated the case for a “deflationary rut.” This chart shows that 49% of the prediction market expects the Fed to deliver. That is a pretty good percentage although we of course would prefer higher. Wolfers focuses in on the skew of expectations; that is, the people who think the Fed will miss the mark on inflation are predominantly expecting an undershoot. Note that only 1% of the prediction market currently expects deflation in the next 5 years. I do NOT equate an expectation of missing the 2% the target as a deflationary risk.

The main lesson for those of expecting Fed policy to lead to excessive inflation is that we remain a distinct minority. Very few people are worrying about inflation in financial markets.

Wolfers provides this good caveat on interpreting prediction markets:

“Of course, the specific probabilities inferred from market prices should be taken with many grains of salt. In particular, traders may not be betting that prolonged deflation is probable, but rather be buying insurance against such a grim occurrence. Thus, prediction market prices might overstate the probability of bad outcomes. Nonetheless, these prices embed a powerful message for policy makers: Just as people buy flood insurance when they’re concerned that a storm might do terrible damage, traders might be buying deflation insurance because they fear the risk of vast economic damage if the economy were to enter a deflationary rut.”

And a nice message for those of us expecting problems with inflation in the near future:

“Next time people tell you that higher inflation is coming, remind them that they can get rich in the derivatives markets if they’re willing to put their money where their mouth is.”

In the end, seeing Wolfers turn relatively mild data into a warning on deflationary risks is yet one more example of how deflationist psychology persists in economic thinking despite years of accommodative Fed policy, lots of money printing, and more printing to come…

It's a wonder sometimes that gold has been able to hold on as high as it is...

It’s a wonder sometimes that gold has been able to hold on as high as it is…

Full disclosure: long GLD


The Fed Asks “What Inflation?”

Last week, headlines and pundits were hot and bothered about the potential for the Federal Reserve to fall behind the curve on inflation. While my on-going assumption is that the Fed will indeed chose much higher inflation rather than risk ending the economic recovery with higher rates, I think the current hand-wringing by some is premature. In fact, it seems more the result of either boredom with the Fed’s business as usual policy stance and/or the anxiety on the part of some stock market bears looking for any kind of catalyst to shake the market out of its low volatility slumber

I was so surprised at all the hand-wringing over a “business as usual” policy statement that I rolled the tape on the press conference. I was wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.

Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman of CNBC:

“Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it’s above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?”

 

This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation remain tame (also see the Fed’s latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunge from there. Not only might it be premature to project a 2% reading for next week’s release, but there is nothing to suggest that this time is different. The Federal Reserve has the least control over the non-core prices of food and energy, so the escalation of violence and turmoil in Iraq is definitely not the kind of event that the Fed would try to offset with monetary policy.

 

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The Fed still can’t tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve

Perhap’s Yellen’s poor response ignited the flames of disappointment. Yellen did not address PCE directly and instead talked about the noise in the Consumer Price Index (CPI) while reiterating the Fed’s standard guidance on inflation:

“So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it’s–the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.”

Ironically, Yellen could have just pointed to the longer-term trend in the CPI. This view dominates any shorter-term noise….

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The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve

The most bizarre part of the buzz on the Fed’s supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:

“…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn’t changed at all in terms of the committee’s tolerance for permanent deviations from our objective.”

This was Yellen’s response to Liesman asking about the Fed’s tolerance for higher-than-target inflation.

I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (GLD) and silver (SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the “inflation genie” would already be out the bottle. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.

 So, overall, I am very skeptical that this episode is the long-awaited lift-off of inflation and a lagging Fed. I actually think the Fed is right to look through the current “warming” in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King. When the Fed asks “what inflation”, I find myself surprisingly agreeing for now…

To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. Just do a web search or read mainstream financial magazines to see anecdotally how many people are still worried about the sustainability of the so far very weak housing recovery. I find it hard to believe we will get strong inflation with all this weakness and deflationary fears. On the commodity side, copper and iron ore have experienced major price declines in recent months that also fly in the face of any kind of sustained inflationary pressure in the economy.

Full disclosure: long GLD, SLV.


The IMF Launches “Global Housing Watch”

Housing prices are on the march again across the globe, and the International Monetary Fund (IMF) is concerned. In response, the IMF has launched a site it calls the “Global Housing Watch.”

Here is the introduction:

“Housing is an essential sector of every country’s economy, but it has also been a source of instability for financial institutions and countries. Understanding the drivers of house price cycles, and how to moderate these cycles, is important for economic stability.

 

The new indicators are an important step in assembling country-level data on housing trends in one location, allowing for more transparent cross-country and historical comparisons. The hope is to prompt actions by policymakers to moderate housing cycles.”

Housing has been a natural beneficiary of loose monetary policies. The irony or dilemma in extremely expensive countries like the United Kingdom, Canada, France, and Australia is that overall inflation readings are low. Accordingly central banks are maintaining extremely accomodative monetary policies in these countries. Thus, the traditional brakes for the housing market, higher rates and tighter monetary policy, are absent and nowhere on the horizon. It is no accident that the Bank of Canada and the Bank of England are now talking more loudly about using macroprudential policies to contain housing markets and enforce standard of financial stability. Here are the related recommendations coming from the IMF: 

“We do have a set of policy tools that can help – sometimes these are referred to as “Mip-Map-Mop.” Microprudential (Mip) policies look at an individual bank’s balance sheet, for example to determine if it is making too many real estate loans. But it could be that the individual banks are doing what seems healthy for them, but what the banking system as a whole is doing needs results in an unhealthy growth in lending.

 

So, in addition, macroprudential regulations (Map), operating at the level of the financial sector as a whole, come into play. The most commonly used measures cap how much individuals may borrow relative to their income. These prudential measures are being increasingly used by countries to prevent an unsustainable build-up in debt.

 

Finally, there is the monetary policy (Mop) that involves the central bank raising interest rates if they want to cool off the housing sector. This can be tricky, because sometimes the economy is weak but the housing sector is booming, and raising the interest rate can harm the overall economy.

So, basically, we need to share experience across countries, to look at trends, use our judgment, and apply policies that that may help prevent problems in the housing sector.””

I will be keeping an eye on this website and the twitter hastag #HousingWatch. I expect some revealing and fascinating data to flow through here. Here are the charts posted on the site showing the relative valuations of housing across the globe. I highly encourage the reader to go directly to the website and browse for yourself.  I also hope to write some pieces covering the housing markets in the UK, Canada, and Australia in particular in coming weeks and months.

Note well that the U.S. is NOT in bubble territory (in the aggregate)….

 

 

 

 

 

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Over-stretching the case for inflation

I continue to think it makes more sense to fear inflation than deflation, but I cringe when I read “inflationists” who continue to over-state the case for inflation. Two recent pieces that appeared in Project Syndicate are case in point: “When Inflation Doves Cry” by Allan Meltzer and “The Ghost of Inflation Future” by Brigitte Granville.

Allan Meltzer wrote “A History of the Federal Reserve” and is considered an expert on the Federal Reserve. He wrote recently to complain about a cover story in the Wall Street Journal that declared victory for the inflation doves over the hawks. Meltzer essentially called the doves lucky. He insisted that the lack of inflation despite the Federal Reserve’s massive growth in its balance sheet was something no one on either side of the divide predicted. I actually seem to recall plenty of deflationists from 2008 to this very day who have scoffed at the notion that the Fed can do anything to stop an eventual deflationary collapse. So, I think Meltzer is too broad in trying to excuse himself for being wrong all these years about the immediate inflationary consequence of quantitative easing (for Meltzer’s dire warnings on inflation early in the crisis see his 2009 interview on EconTalk).

Even more problematic for me is that Meltzer calls on the Federal Reserve to stop paying interest on reserves, the very thing that is containing the kind of increase in the monetary supply that will surely boost inflationary pressures. Meltzer also seems to imply that the Fed should simultaneously raise interest rates and work down the reserves on the balance sheet. These two prescriptions strike me as deflationary. I suppose there is some formula whereby all these can be done in a harmony that can spur non-inflationary growth and avoid deflation, but Meltzer does not make it specific. (It is also possible that the strict limits on article length in Project Syndicate made it impossible for him to clarify).

In 2010, Mletzer wrote in the Wall Street Journal that eventually banks would start loaning out the money currently held in reserves. The only reason to do this would be if banks felt they could make more money than simply accepting the free money from the Fed. Meltzer did not say what would motivate such lending except to suggest that the Fed would get the rate on reserves wrong. Now, three years later, to advise that the Fed drop the rate altogether is to ask for a free pass to make a prophecy come true.

Mind you, I am sympathetic to the case that says the Fed will not be able to contain inflation when it finally starts up again, but the specific mechanism for a reignition of inflation is still not quite clear yet in my opinion. The Fed seems inclined to maintain an accomodative stance well into an economic recovery in order to ensure that the recovery has firm roots. That bias is certainly the seed from which inflationary pressures can (will) grow…but we need that recovery first!

Brigitte Granville wrote “Remembering Inflation” which makes the case for establishing inflation targets as a tool for maintaining the inflation-fighting credibility that central banks need to foster stable prices (see summary at Princeton University Prcess). In her piece on Project Syndicate she concludes by warning that Europe will soon go from depression to high inflation. It is a bewildering prediction given she acknowledges that the European Central Bank cannot raise its inflation target, and its program of “outright monetary transactions” must be accompanied with tight fiscal policies. In many ways, the ECB is acting as if it fears inflation more than deflation. Moreover, Granville notes that as a consequence heavily indebted nations in the eurozone will eventually be forced to restructure their debt with creditors (instead of attempting to inflate away the debt with a devalued currency). Without a devlation in the currency, I have a hard time understanding how such restructuring will trigger inflation. Instead, it is likely to make it even more difficult for borrowers in these countries to access the credit markets, sterilizing an important inflation-generating mechanism.

We inflationists have been premature and even wrong on our inflation expectations. Here on Inflation Watch, I finally acknowledged back in June that it was time to cool my inflation expectations. I still promise to maintain vigil and write related pieces, but it just does not make sense to write in such expectant tones…at least not until something fundamentally changes in the inflation picture. In the meantime, inflationists would do well to avoid predictions of inflation until they (we) can specifically describe exactly how (and when?) the inflationary threat will manifest itself. The odds for an imminent inflationary spiral are NOT 100%, probably not even 80%…


Inflation May Be Dead, But Inflation Watch Is Not

Things have been pretty quiet around here. Every now and then I see a story about rising prices somewhere in the world and think the story would make a great quick post for Inflation Watch. However, I usually do not feel the same sense of urgency I had from 2008 through about 2011 when I felt that rapid inflation was the imminent result of extremely accomodative monetary policy. Everywhere I look, commodities continue to decline in price. Most commodities reached a peak in 2011 and that peak of course had me convinced more than ever that inflation was soon to be a big problem.

Now, thanks to a friend, I am ever closer to accepting that inflation may not be a problem for an even longer time than I expected. He sent me a link to an article called “The Fed won’t taper as long as inflation is low” (by Rex Nutting at MarketWatch) that makes the convincing case that not only is inflation low, but the Federal Reserve has so far seemed powerless to generate the inflation it wants. (I recognize the limitations of government data on inflation, but I do not subscribe to theories that they are concocted specifically to hide true inflation). Incredibly, core inflation is apparently at its lowest point since 1959 (the core PCE price index):

Rex Nutting uses this graph to make the point that all the Fed's QE have failed to go reflate according to the Fed's goals

Rex Nutting uses this graph to make the point that all the Fed’s QE have failed to go reflate according to the Fed’s goals

Nutting also links to a paper from the Federal Reserve Bank of New York called “Drilling Down into Core Inflation: Goods versus Services.” In this paper, authors M. Henry Linder, Richard Peach, and Robert Rich demonstrate that more accurate inflation forecasts come from breaking out CPI into a services and a goods component. Nutting uses this as reference for the claim that the Fed is failing because of global disinflation. This global disinflation is responsible for a decline in the prices of the goods component. Services inflation is much more sensitive to domestic forces (we all know about skyrocketing healthcare and education costs). However, I am not sure where housing sits on this spectrum. It seems to provide a crossroad of forces given housing is not tradeable but foreigners are certainly free to overwhelm a housing market with cash. Foreign demand is reportedly helping to drive up housing prices in some of America’s hottest housing markets like in California and some parts of Florida.

All this to say that, for the moment, inflation is all but dead. But “Inflation Watch”, this blog, is NOT dead. I remain vigilant because I believe that when inflation DOES come, the Federal Reserve will either be ill-equipped to handle it and/or unwilling to snip it early for fear of causing a severe economic calamity. I am a gold investor, and I am eager for another chance to invest in the midst of a commodity crash (I am LONG overdue for an update to my framework for investing in commodity crashes/sell-offs).

The chart below from the Reserve Bank of Australia (RBA) shows that commodity prices remain at historically high levels, mostly thanks to rapacious demand from China. The current relative decline is what is helping to drive goods inflation down. The 2011 peak was well above the pre-crisis peak where prices have fallen now. Also note that prices are much more volatile. I suggest that this chart should remind us that commodity prices are a tinder box that can flare up at anytime. Aggressive rate-cutting by the RBA should also help keep prices aloft.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

So stay tuned. Just when everyone finally concludes that the world has reached a golden age of disinflation where surpluses abound across the planet…that could be the exact moment the tide turns.

Be careful out there!

Full disclosure: long GLD


The UK’s CPI inflation to remain stubbornly high for the next two years

On February 7th, The Monetary Policy Committee (MPC) of the Bank of England (BoE) decided to leave interest rates at the rock bottom rate of 0.5%. In doing so, the MPC acknowledged that it was assuming that the current stubbornly high inflation would eventually return to the target 2%. The MPC is expecting productivity gains and the reduction in external price pressures to do the trick.

“Inflation has remained stubbornly above the 2% target. Despite subdued pay growth, weak productivity has meant no corresponding fall in domestic cost pressures. And increases in university tuition fees and domestic energy bills, largely resulting from administrative decisions rather than market forces, have added to inflation more recently. CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, in part reflecting a persistent inflationary impact both from administered and regulated prices and the recent decline in sterling. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade.”

I took particular interest in the claim that external price pressures will fade. To do so, the global economy would have to remain weak. If so, then it is unlikely that growth in the UK will fare much better, even at the projected “slow but sustained” pace. The other possibility is that the British pound or sterling – CurrencyShares British Pound Sterling Trust (FXB) – appreciates enough that external prices go back down. If so, then Mervyn King’s hopes of rebalancing the economy with a reduction in demand for imports and an increase in exports surely will not be realized.

Adding to this conundrum for the UK economy is the stubborn persistence of weak economic growth (mainly flat) along with strong employment growth. The UK economy is getting less and less productive and thus less and less capable of offsetting inflationary pressures. This is a dynamic that I will be watching ever more closely given the BoE projects a two-year horizon over which the economy will continue to suffer high inflation and weak economic growth (aka stagflation). The implication for the currency is mixed, and I continue to expect “more of the same” for the pound.