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.!
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
Residents of San Jose, CA will vote in November on whether to raise the city’s minimum wage 25% from $8 to $10. The proposed law includes annual adjustments for inflation. This law will be similar to a minimum wage ordinance put into law in San Francisco.
I expect to hear a lot of economists weigh in on this issue, but it was interesting to read one councilwoman say that this is an economic AND a moral issue. Given these higher wages will be paid by businesses and consumers (that is, the law will nt suddenly create new money that was previously non-existent), I think introducing morality will cloud proper analysis.
I am also now interested to know whether anyone has studied the impact of the minimum wage law in San Francisco. It seems strange to me that cities in the same metro area could have dramatically different minimum wages. For low margin businesses that can move, they will prefer to go to lower wage cities. Workers will tend to look for work in the higher wage city but will also face impossibly high housing costs, resulting in commutes that can nullify wage gains. These are just a few examples of things that economists might study.
For more details see “San Jose City Council leaves minimum-wage hike to voters” in the San Jose Mercury News.
Inflation in the United Kingdom has been stubbornly and persistently high since the recession ended – it is currently 3% and above the Bank of England’s (BoE) target of 2%. The UK has been unique amongst the major economic partners in experiencing high inflation and slow growth since the recession. Through this period the BoE has insisted that it expects inflation to eventually (and soon) decline towards target. Every year that passes without the target getting hit, produces another year of frustration and impatience. Now that the UK has recorded two quarters of negative GDP growth, stagnation has descended upon the economy.
In last week’s Inflation Report, the BoE made an admission I do not think I have heard before. A reporter asked the expected and on-going question about the inflation problem. A BoE member answered that the depreciation of the British pound has contributed to driving inflation higher than expected. He noted that the BoE expected currency depreciation to behave as it did in the 1990s when it seemed not to contribute to inflation. Instead, the UK is getting the experience of the 1970s and 1980s. There was no discussion about the lessons learned or what features of all these periods are similar or different. However, I think this is huge progress that at least the BoE has officially recognized that a less valuable currency can still contribute to high inflation.