That was the week that was – Sunday February 21, 2016


Maybe because it was a four-day week in the US but equity markets were remarkably robust. The S&P500 consolidated its rebound from the bad early February news. The FOMC Minutes were a non-event as expected but a swing voter, Bullard, did turn more dovish. He swings a lot, to be honest, but at least he swings. Perhaps we’d score Bullard 2 out of 10 on a usefulness rating, but at least not negative. That said, there was no recovery from the sharp January set-backs to equities.

This overall lethargy was seen in bond markets, TIPS and the US Dollar too. There were no significant moves in any financial markets over the shortened week.

The inflation hawks were all crowing about the slightly higher than expected US CPI numbers but the markets yawned. Tellingly, the markets that feed the market-implied inflation forecasts kept the expectations at the record lows achieved in recent weeks.

Topic of the week: CPI (and the PCE)

Back in 2007-08 when higher oil prices caused headline CPI to surge core CPI, excluding energy didn’t move much. What would have happened if the Fed hadn’t tightened monetary policy? We would probably have seen core CPI shift down a bit as demand for non-energy goods and services fell. A relative price adjustment would have occurred. Headline CPI would have fallen back over time too. What happened was that the Fed tightened and both headline and core CPI crashed.

Over the last 18 months we have seen a dramatic drop in oil prices so that energy-related goods and services prices have fallen. This has reduced headline CPI, as you would expect. Over time non-energy related prices will rise a bit as demand can be redirected towards non-energy related goods and services, driving up their prices. Another relative price adjustment will have taken place. And current core CPI becomes a poor guide to future headline CPI.

So, while the hawks get excited about price growth in various service sector segments, medical, education and rented housing, Market Monetarists prefer to look at aggregates. There will always be some segment or other seeing higher pricing pressure, but the aggregate is what matters. The high oil prices of 2007-08 did not feed into other segments because money was tight and NGDP growth expectations weak. Money is still tight so if certain segments like medical, education and rented housing continue to see growth other segments will necessarily see pull backs in demand and price. Something will have to give since there just isn’t the money to go around.

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The Fed claims it watches the Personal Consumption Expenditure (PCE) inflation gauge, especially the Core PCE. It generally runs 0.5% below the Core CPI. It has been far steadier. PCE more quickly reacts to changes in patterns of spending, as it changes its composition monthly and is based on actual expenditures by and on behalf of consumers (by their employers), so it will pick up relative price movements much more quickly than CPI. Housing (shelter costs) has only about half the weight in the PCE as in the CPI.

Of course, both CPI and PCE are only price indexes and thus have all the drawbacks of trying to measure “inflation”, particularly when one considers quality or hedonic adjustments. Hedonic adjustments are tricky enough in “easy” sectors that produce goods, but are massively complex in the service sector. How do you measure quality changes in healthcare or education? Many argue that the huge rise in student loans and consequent rapid expansion of college education has massively reduced the quality.

In addition, if consumers rush to spend their savings on fuel by buying other things (healthcare and education, say) do those industries produce more or just raise prices? It’s not easy to tell. It seems unlikely they will produce more on a 1:1 basis, the supply curve will be sloped. The flip side could be lower productivity in those sectors, just as productivity has shot through the roof in the shale oil sector.

We say the FOMC “claims” to watch core PCE because in 2008 many members of the FOMC were transfixed by headline inflation numbers, even CPI ones. The FOMC missed the collapse in NGDP growth expectations and tightened monetary policy, the rest is history.

The seeming paradox of trending higher “inflation” versus trending lower NGDP is solved by looking at trending lower RGDP. Something has to give.

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If inflation really is trending higher, yet NGDP trends lower, it is inevitable. The other side of a fall in the contribution of real growth as a percentage share of nominal growth is that productivity growth must be recorded as low/falling. And that is exactly what the US is seeing.

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There was no significant economic data this week either. The Atlanta Fed GDPNow didn’t’ budge. Next week is more interesting with the January durable goods orders influencing investment spending component of GDP(E), i.e. measured by expenditure. It’s a small part but volatile, especially the really volatile inventory sub-component. There will also be the release of the January personal income and outlays that impacts the Personal Consumption Expenditure element of GDP. This is an echo, of the already released January Retail sales figures. In some ways it is more considered, but includes more steady but more theoretical items like housing expenditure, either actual for renters or implied for home-owners.

As we move to the end of the 2nd month of the quarter, the 1st month numbers become naturally less interesting. Surveys of current and future activity become more important to the market, like from the Conference Board on consumer confidence and the Markit Services PMI.

Base money growth for the week to 17th February finally ended its run of negative year on year growth. It seems as if Base Money is returning to the levels of 2015. It is remarkable how badly Base Money reacted immediately pre and post the Fed actual tightening. As the markets have forced the Fed to back off, so Base Money recovers.

Next week has some interesting data for sure. The more reliable consumption and consumption price data. The BEA will produce a 2nd estimate of RGDP at the end of the week, probably weaker than first reported now that December data has been more fully collected. There is also a Chicago Booth conference on monetary policy with lots of FOMC’ers and the G20 in China starting next Friday.


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