We anticipate monitor and comment on market-moving global economic and geopolitical issues. No dark side brooding, no wanting the world to end, no political rants. Traders, investors, policymakers, or market observers can’t afford to ignore us. In one word, perspicacity.
An educated citizenry is a vital requisite for our survival as a free people. – Thomas Jefferson
CPI inflation hit 9.1 percent in June. The FinMedia is quick to point out it was “the highest level in more than forty years,” We doubt you will hear (at least from them) any context or the rest of the story. So here you go:
History Not On Inflation’s Side
We looked at the inflation data going back to 1914, and our analysis surprised even us. Monthly annual CPI inflation has initially breached 9.0 percent only six times over the past hundred years – seven counting June 2022 (see chart above).
Once busting through the 9 percent (y/y) mark, inflation has never peaked or retreated from that level but only accelerated or stayed elevated for several consecutive months. The four-month streak during the Korean War was the shortest and is referenced by the following:
Worth Reiterating: Inflation Streaks When It Surpasses 9 Percent
Let’s repeat that. Once inflation initially breaches 9 percent, there has never been a case in the history of the data that it peaked or stopped there. This is so au contraire to the conventional wisdom of the markets that inflation has peaked, and the Fed is ready to “pivot.” Maybe “this time is different,” but we loathe those words and always make it a point to run away and fast when we hear them.
Behavior Changes As Inflation Increases
Economic agents change their behavior when inflation increases, especially as it approaches double digits. The willingness to hold cash balances diminishes, and money velocity, the inverse of money demand, increases when inflation starts to creep higher, causing more inflation. Central banks have found this feedback loop very difficult to break.
The problem is there is no clear or realistic definition of “money” and how to measure it. There is both exogenous money created by the central banks and endogenous money created by the private sector.
Inflation Is A Macro Concept
Quantity Theory Of Money
MV = PY
where, M = Money V = Velocity P = Price Level Y = Real GDP or production
Moreover, inflation, similar to the trade deficit, is a macro concept. Supply shocks don’t cause inflation unless they are monetized. Supply shocks cause relative price shifts, either temporary or permanent, and consumers and producers adjust their behavior and budgets accordingly.
Similarly, the overall trade or current account deficit is not the result of tariffs or trade policies but a macro concept:
In our recent observations, we suspect few genuinely understand the difference between changes in relative prices and inflation, even among some “so-called” economists.
Exogenous vs. Endogenous Money
We have a pretty good idea of how much “exogenous money” has increased, more than $10 trillion, or around 50%, by the major central banks, over the past few years. It is nearly impossible to quantify or measure the money, as loosely defined, that the private sector has created, which the Fed is fighting hard to control and slow by raising interest rates.
If I had to use one simple example today to explain what is going on with inflation, it would be the following picture of a bathtub overflowing:
Assume the water in the tub above is the global economy’s liquidity, which drives aggregate demand for goods and assets. It consists of the exogenous or base money created by the central banks and endogenous money created by the private markets.
My 19-year daughter, for example, recently received an offer for an $18k line of credit and was able to take out a car loan with no cosigner at a rate less than 3.0 percent.
The overflow is also the inflation now wreaking havoc in the goods & services market.
Interest Rate Hikes To Slow Endogenous Money
The Fed is trying to slow or reduce the flow of endogenous money through interest hikes. July’s massive stock and credit rally are indicators that financial conditions in the U.S. are easier than last month, even as the Fed tightens. That’s not inflation (as in going down) positive, folks.
The Fed plans to extract $2 trillion of exogenous money from the liquidity tub throughout 2023, which should make life interesting.
Money will get tight (the water level in the bathtub will recede) if the Fed follows through with its tough talk, but given the action of the markets over the past few months, the markets don’t believe the Fed and/or the “neutral rate” is nowhere even close.
Come on, man, a neutral funds rate at a negative 7 percent real rate? Seriously?
High inflation is a positive for nominal corporate revenues, which are showing up in the recent earning releases adding vigor and rationalizing the market rally. Monetary policy has yet to really bite.
Yeah, yeah, the yield curve inversion in a distorted bond market. Someday we will have a recession, and eventually, someday, I am going to die — the yield curve inversion is telling me so. Timing is everything.
Where is a law that states inflation can’t coexist with lower economic growth or recession? Not a bad “useful delusion” for the markets to grasp onto, however.
Old Monetary Aggregates
We view the old monetary aggregates – M1, M2, etc. – about as useless as the price of horseshoes as a leading indicator for the economy. Why isn’t my Schwab margin account counted as a deposit in the monetary aggregates? I can write checks from it.
Nevertheless, we can still glean a slight sense of what the economy is doing by looking at the old aggregates. Still, when, say, an asset class such as crypto can be created out of nothing, produce nothing, be leveraged and monetized to buy, say, Teslas, we consider that money in the true sense as it creates purchasing power. It is inflationary, by the way. In contrast, the crypto crash has been deflationary on the margin.
The recent massive rally in stocks, spread product, credit, and the growth and creation of alternative spec assets, such as crypto and NFTs, are money to us and becoming more authentic. As FinTech advances, assets become more liquid, complicated, and easier to use as collateral and leverage, understanding and making monetary policy becomes much more difficult.
Inflation “Hitting Streaks” Throughout History
The table below illustrates how and for how long inflation streaks when it blows through 9 percent. Notice all periods occurred during or near wars and/or significant supply shocks – WWI, Spanish Flu, WWII, OPEC I & II, COVID & Ukraine. This renders the deflationitas’ arguments that current inflation is a special case due to supply shocks almost laughable.
The “in the past forty years” 9 plus percent inflation print the financial media uses to compare the June 9.1 percent print occurred in November 1981, when inflation was dropping -like a stone and financial conditions in the U.S. were very tight. A more correct comparison should be the 9 percent inflation prints of 1975 when inflation exceeded 9 percent, and financial conditions were as easy as they are today.
The NFCI provides a comprehensive update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.
Positive values of the NFCI are associated with tighter-than-average financial conditions, while negative values with looser-than-average financial conditions. The NFCI is a weighted average of a large number of variables, 105 financial indicators that can be found here,
Current Financial Conditions
Even with the Fed’s mega rate hikes since March, financial conditions are still loose in the U.S., as reflected by the red dot in the lower left corner of the scatter diagram.
A 9 percent monthly year-on-year inflation rate with still loose financial conditions doesn’t take a genius to project the most likely trajectory for inflation over the near term. Yes, gas prices are falling but only make up less than 4 percent of the CPI basket.
There was some rare good news out of Ukraine today when a vessel loaded with 26,000 tons of corn left the port of Odesa — the first legal shipment of grain since Russia’s invasion began in late February.
It’s a small step but potentially significant for some of the world’s poorest countries as they wrestle with soaring food prices caused in part by uncertainty over supplies of millions of tons of Ukrainian grain blocked by Russia’s assault. – Bloomberg
The BLS reports CPI inflation tomorrow with the expectations of the print in the above table.
We are taking the under on the overall consensus expectation of 1.1 percent and the over on the core of 0.5 percent. All based on anecdotal evidence as we see gas and avocado prices plummeting over the past few weeks and rents skyrocketing.
Nevertheless, the BLS has really painted itself in a corner with how they measure housing inflation.
We have been beating this dead horse for years, and now it has risen from the dead and will bite the BLS and the inflation figures in the arse. For the first time since its inception, the new measure of housing (OER – Owners Equivalent Rent) will be tested in a high inflation environment.
How odd is it that housing prices are softening, but a fixed-rate mortgage is up almost 100 percent in the last twelve months? Moreover, what if homeowners get the Airbnb bug and believe they can rent their homes at the Airbnb rate? That’s trouble with a capital T for the inflation figures, folks, as OER is 25 percent of the CPI basket.
The Los Angeles Times printed a good piece yesterday, which sounded like the Global Macro Monitor.
Annual rental costs for new tenants jumped from 4.3% in July 2021 to 11.1% in March 2022. For existing tenants, inflation was lower and grew at a slower pace over that period, climbing from 1.5% to 2.7%. For residents of owner-occupied units, the trend was similar. (BLS is expected to release inflation data for June on Wednesday.)
With the spread between the new-renter and continuing-tenant rates at an all-time high, according to BLS data, that bias is even more pronounced than usual. That gives new ammunition to critics who have argued the data published by the BLS fail to reflect the severity of housing inflation, especially in states such as California, where the cost of housing is higher.
Beyond masking the extent of inflation faced by new tenants, Sohn said, the agency also distorts the market’s reality with the way it calculates the cost of housing ownership. Almost two-thirds of Americans live in homes they own.
Since 1983, BLS has approximated the rental value of owner-occupied homes by measuring the rent paid by tenants in the same vicinity. This is then translated into a rent equivalent.
“To me, the owner-occupied rent is somewhat a wild guess in the official data,” Sohn said. “If I were to rent my own house to myself right now when the price rise is really high, I would be paying much more than what an apartment rent would charge but the BLS wouldn’t reflect that necessarily.
”This data is evidence that rents are going up very fast, faster than they have been, for new tenants after a long period of slower price growth,” said David Wessel, director of the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy.
Past trends suggest it’s only a matter of time before the higher inflation rate spills over into renewals as well, he said. – LA Times
Looks like he will soon be back in action with a vengeance:
A record share of new car shoppers are being saddled with monthly payments topping $1,000, according to June data from Edmunds. That’s higher than the average cost of rent in 24 US metro areas on the Zumper National Rent Report. Meanwhile, the average monthly car payment reached $712 in May, according to Cox Automotive. That’s higher than rent for one-bedroom apartments in cities like Wichita, Kansas, and Akron, Ohio. – Bloomberg
What could possibly go wrong? FOMO in the used car market….Geez!
It appears the used car bubble is going to burst. Bummer, my daughter just bought a used VW yesterday. No worries, she is not a flipper and got a very good price.
The coming deflation – yes, lower prices and not “disinflation“, which in the words of Wolf Blitzer, is “happening now” – in used car prices will dampen CPI inflation on the margin, even though they are only about 4 percent of the CPI basket.
The butterfly effect is the concept that small causes can have large effects. Initially, it was used with weather prediction but later the term became a metaphor used in and out of science.
In chaos theory, the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a deterministic nonlinear system can result in large differences in a later state. The name, coined by Edward Lorenz for the effect which had been known long before, is derived from the metaphorical example of the details of a tornado (exact time of formation, exact path taken) being influenced by minor perturbations such as the flapping of the wings of a distant butterfly several weeks earlier. Lorenz discovered the effect when he observed that runs of his weather model with initial condition data that was rounded in a seemingly inconsequential manner would fail to reproduce the results of runs with the unrounded initial condition data. A very small change in initial conditions had created a significantly different outcome. — Wikipedia
On this day in history, June 28, 1914, the driver for Archduke Franz Ferdinand, nephew of Emperor Franz Josef and heir to the Austro-Hungarian Empire, made a wrong turn onto Franzjosefstrasse in Sarajevo.
Just hours earlier, Franz Ferdinand narrowly escaped assassination as a bomb bounced off his car as he and his wife, Sophie, traveled from the local train station to the city’s civic city. Rather than making the wrong turn onto Franz Josef Street, the car was supposed to travel on the river expressway allowing for a higher speed ensuring the Archduke’s safety.
Yet, somehow, the driver made a fatal mistake and tuned onto Franz Josef Street.
The 19-year-old anarchist and Serbian nationalist, Gavrilo Princip, who was part of a small group who had traveled to Sarajevo to kill the Archduke, and a cohort of the earlier bomb thrower, was on his way home thinking the plot had failed. He stopped for a sandwich on Franz Josef Street.
Seeing the driver of the Archduke’s car trying to back up onto the river expressway, Princi seized the opportunity and fired into the car, shooting Franz Ferdinand and Sophie at point-blank range, killing both.
That small wrong turn, aminor perturbation to the initial conditions, or deviation from the original plan, set off the chain events that led to World War I.
Stumbling Into The Great War Fearing Russian support of Serbia, Franz Josef would not retaliate by invading Serbia unless he was assured he had the backing of Germany. It is uncertain as to whether the Kaiser gave Franz Josef Germany’s unequivocal support. Russia, fearing Germany would intervene, mobilized its troops forcing Germany’s hand.
The great European powers thus stumbled into a war they didn’t want through complicated entanglements and alliances, and miscalculation. Russia backing Serbia; France aligned with Russia, Germany backing the Austro-Hungarian Empire; and Britian, who really didn’t have a dog in the fight except her economic interests, aligned with France and Russia.
Later the U.S. would enter the war due to Germany’s unrestricted submarine warfare threatening American merchant ships and the Kaiser floating the idea of an alliance with Mexico in the famous Zimmerman Telegram, which was intercepted by the British.
Of course, some will argue that Great War in Europe was inevitable
The great Prussian statesman Otto von Bismarck, the man most responsible for the unification of Germany in 1871, was quoted as saying at the end of his life that “One day the great European War will come out of some damned foolish thing in the Balkans.” It went as he predicted. – History.com
Nevertheless, maybe the course of history would have been different if not for that wrong turn on June 28, 1914, which created the humongous butterfly effect, which we still experience the consequences this very day.
A map marked with crude chinagraph-pencil in the second decade of the 20th Century shows the ambition – and folly – of the 100-year old British-French plan that helped create the modern-day Middle East.
Straight lines make uncomplicated borders. Most probably that was the reason why most of the lines that Mark Sykes, representing the British government, and Francois Georges-Picot, from the French government, agreed upon in 1916 were straight ones. — BBC News
If Franz Ferdinand had not been murdered on this day in history, that conflict between the Serbs and the Austro-Hungarian Empire may have been contained to just the Balkans. Maybe.
The butterfly effect. Think how many small events, decisions, mistakes, one small turn, or “minor perturbations” in plans have had enormous consequences in your own personal life.