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.
Source: NPR Planet Money
Cross-Post: The Canadian Dollar’s Rapid Devaluation Presents An Inflation Predicament for the Bank of CanadaPosted: January 23, 2016
(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.
Source: Oanda’s CFTC’s Commitments of Traders
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
Prescription for preventing housing bubbles from the IMF…
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.
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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….
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…
Full disclosure: long GLD
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.
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….
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.
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)….
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%…