U.S. Breakeven Inflation Comments

I just refreshed my favourite U.S. breakeven inflation chart (above), and I was surprised by how placid pricing has been. This article gives a few observations regarding the implications of TIPS pricing.

Background note: the breakeven inflation rate is the inflation rate that results in an inflation-linked bond — TIPS in the U.S. market — having the same total return as a conventional bond. If we assume that there are no risk premia, then it can be interpreted as “what the market is pricing in for inflation.” I have a free online primer here, as well as a book on the subject.

(As an aside, I often run into people who argue that “breakeven inflation has nothing to do with inflation/inflation forecasts.” I discuss this topic in greater depth in my book, but the premise that inflation breakevens have nothing to do with inflation only makes sense from a very short term trading perspective — long-term valuation is based on the breakeven rate versus realised inflation.)

The top panel shows the 10-year breakeven inflation rate. Although it scooted upwards after the pandemic, it is below where is was pre-Financial Crisis, and roughly in line with the immediate post-crisis period. (Breakevens fell at the end of the 2010s due to persistent misses of the inflation target to the downside.) Despite all the barrels of virtual ink being dumped on the topic of inflation, there is pretty much no inflation risk premium in pricing.

The bottom panel shows forward breakeven inflation: the 5-year rate starting 5 years in the future. (The 10-year breakeven inflation rate is (roughly) the average of the 5-year spot rate — not shown — and that forward rate.) It is actually lower than its “usual” level pre-2014, and did not really budge after recovering from its post-recession dip. (My uninformed guess is that the forward rate was depressed because inflation bulls bid up the front breakevens — because they were the most affected by an inflation shock — while inflation bears would have focussed more on long-dated breakevens, with the forward being mechanically depressed as a result.)

Since I am not offering investment advice, all I can observe is the following.

• Since it looks like one would need a magnifying glass to find an inflation risk premium, TIPS do seem like a “non-expensive” inflation hedge. (I use “non-expensive” since they do not look cheap.) Might be less painful than short duration positions (if one were inclined to do that).

• Breakeven volatility is way more boring than I would have expected based on the recent movements in inflation. The undershoot during the recession was not too surprising given negative oil prices and expectations of another lost decade, but the response to the inflation spike was restrained.

• The “message for the economy” is that market pricing suggests that either inflation reverts on its own, or the Fed is expected to break something bigger than a few hapless regional banks if inflation does not in fact revert.

Otherwise, I am preparing for a video panel on MMT at the Canadian Economics Association 2023 Conference on Tuesday. (One needs to pay the conference fee to see the panel.) I have also been puttering around with my inflation book. I have a couple draft sections that I might put up in the coming days/weeks.

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(c) Brian Romanchuk 2023

Pleading The Fifth On The Fourteenth

I am currently working on another article, but given the clamour about the debt ceiling, I just want to repeat my stance that I guess a “last minute” deal will be done. I do not expect any unilateral moves to invalidate the debt ceiling ahead of that proverbial last minute. My feeling is that announcing the intention to use any such mechanism is effectively an announcement of an unwillingness to negotiate, which looks bad. Beyond that, I do not see any reason to waste any more of my readers’ time with my takes on that matter.

(I hope to deliver that other article tomorrow.)

The Return Of The Debt Ceiling (Again)

The debt ceiling is being used a negotiating tool in American politics yet again. My concern with American politics is that most things seem to be over-dramatised, while some disturbing things are shoved under the carpet. The debt ceiling is a great source of hysterics from south of the border. My highly non-informed take is that this debt ceiling drama will end in the usual way, going to the 11th hour before some kind of deal is struck.

Default Of Currency Sovereigns

I discussed default risk of sovereigns with floating currencies (“currency sovereigns”) in Understanding Government Finance. The formula that I have settled on: floating currency sovereigns are immune to involuntary default for financial reasons. This is not “floating currency governments cannot default,” rather “the so-called ‘bond vigilantes’ cannot force such a government to default.”

Transitoriness

The latest CPI report for the United States suggests that the inflation spike after 2020 was transitory in the rather weak sense that I understood the term “transitory.” I am curling in a bonspiel over the next few days, so I do have a long time to spend on this article, so I just want to outline my thinking on the topic of “transitory.”

The figure above shows the annual inflation rate of the durable goods component of the CPI in the United States. The spike in the inflation rate has reversed to a roughly flat annual inflation rate. This component is somewhat cherry picked, but I think it is a somewhat “clean” sub-component of the CPI. It avoids the construction lag of the housing component of the CPI, and dodges highly erratic energy prices (which we all know about).

For me, the “transitory” nature of inflation was that after the spike subsided, inflation rates would resume at a level similar to the pre-spike levels. This is different than the 1970s. We can see the spike in mid-1970s, and then the inflation rate stabilised around 5% — which was near the peak of the early 1970s. It then marched higher. The problem in the 1970s was not that inflation went up continuously, rather the underlying trend across cycles was higher.

Obviously, the people who argued that inflation would subside in late 2021 — which was a consensus view, including central bankers — were wrong. I certainly had some sympathies with their views — but I am not claiming to be a forecaster, and my view always was that there was massive uncertainty around the post-lockdown economic trajectory. The forecasting issue during the lockdown period was the uncertainty about firm failures — we dodged the massive failures that were possible. Once it was clear that those failures were not going to happen, it was not rocket science to predict that inflation would be perky given the supply chain disruptions.

However, I am not going to say that inflation is dead and buried — the labour market is still relatively tight when compared to the experience of recent decades. We still have “late cycle” inflation concerns, but the inflation prints are likely to remain closer to the rest of the post-1990s experience — and not the 1970s.

At this point, people will want to give central bankers credit for the turn around in inflation. The problem with that is that this requires some selective editing of the 1970s experience — the central bankers did raise rates, the alleged problem was that real rates were negative. Guess what? In this cycle, real rates were massively negative — at least until inflation rates reversed. Even forward nominal rates were below spot inflation, so forward real rates being positive were still predicated on an inflation reversal.

I have another draft section on the recent inflation experience (for my book) in the works, and I hope to get it out relatively soon.

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(c) Brian Romanchuk 2023

U.S. CPI: Ouch

The CPI report in the United States was a horror show for Team Transitory. Although there were other areas with jumpy prices (e.g., food prices), I think that the housing component (above) is the part I am most concerned about in the near run.

Fed Panics

The Fed revisited some old financial records by hiking by 75 basis points today. This is a signal that they have thrown out whatever remains of the models that suggested that inflation is transitory, and they are hiking until something breaks.

From a central banker’s perspective, this is the optimal strategy. Central banks are part of The Establishment, and inflation is an anathema to The Establishment. No central banker ever got fired for causing a recession.

TIPS Valuation Commentary

A quick glance at U.S. TIPS (inflation-linked bonds) shows that if we abstract past the thorny question of where inflation will be in the next few years, the market has largely reversed the relatively low inflation expectations that developed in the mid-2010s. If one believes that the inflation overshoot seen in recent years will be reversed within a reasonable time span, valuations are near a “fair value” based on historical data. (Of course, past performance is not indicative of future results, yadda, yadda, yadda.) If one is convinced that the secular tide on inflation has turned, TIPS might still be cheap on a longer-term basis.

The top panel of the above figure shows the 5-year and 10-year inflation breakeven inflation rates. (The Treasury breakeven inflation rate for a given maturity is the nominal Treasury yield for that maturity minus the “real” (quoted) yield on the same maturity TIPS. I discuss breakevens at length in my book Breakeven Inflation Analysis. I have an online primer here.) Although not identical, the two breakevens move together.

US Housing Component Of CPI Not Letting Up

Unless I was interested in short-term breakevens, I viewed the consumer price index (CPI) as a lagging indicator and therefore not too exciting. As such, I am not as enthusiastic as other commentators with regards to reading the entrails of the CPI report. My interest was more in the underlying trends, and what we would expect to change. The problem with the U.S. CPI is that one of the most important “underlying” factors is housing — and the housing component has taken off like a rocket.

Fed December Meeting Minutes

The minutes for the December 14-15 Federal Open Market Committee (FOMC) meeting were released, and the apparent hawkishness has at least temporarily caused a tizzy in frothy risk markets. From my perspective, there was not a lot of surprises in there, but I do not put a whole lot of value on micro-Fed watching. No matter what they thought they will do in December 2021, what they will do in June 2022 depends upon the data released between now and then. This article has some probably obvious comments on the outlook, as well as some theoretical rants about the underlying framework.

Labour Market Tightness

The interesting part of the inflation debate is the question of labour market tightness. If we are looking at the CPI, what we see is that many components hit high rates of inflation. This means that we need similar gains in 2022 to keep the CPI from dropping back towards 2% or whatever. The more interesting issue is whether strong wage gains will continue, as that increased purchasing power would give a lift to demand and increase purchasing power across all sectors.

The latest U.S. labour market data dump was consistent with continued improvement in the labour market, with the broad employment-to-population ratio rising to 59.2% (figure above). That is well above the lows, and returned to the values seen in middle of the last cycle.

My not very useful observation is that hourly earnings is perkier than would be justified by historical rules of thumb based on macro data. Potential explanations appear to be as follows.

• One explanation I have seen is that wage growth may be more sensitive to the rate of job creation, rather than levels, as is conventionally assumed. (I saw the analysis on the EmployAmerica website, but I cannot remember which blog/report contained it.) Since a good portion of job gains are firms getting back to work after shutdowns, employment growth rates will presumably burn out relatively soon.

• Policies that paid people not to work obviously help tilt bargaining power towards workers. I am unsure as to how much of this effect remains.

• Have workers dropped out of the workforce due to health concerns? This is the story being pushed by the hawks. It is unclear to me how sustainable such a strategy is for workers.

• On a related point, day care employment has not fully recovered, and so workers are effectively locked out of the job market.

• The changing consumption patterns of consumers has invalidated certain modes of operation for firms. So firms could theoretically have the same number of employees, yet need a different mix of workers. This would cause “skills bottlenecks,” even in the absence of net employment growth.

• Certain firms and industries feasted on unsustainable labour practices — being able to call in workers effectively on demand, for example. Even a slight amount of labour market tightening would squeeze out such practices. Meanwhile, there are industries reliant upon pushing capital expenditures to “contractors”: trucking and ride sharing. Sooner or later, the supply of suckers who don’t understand depreciation would dry up.

Projecting high wage growth on a multi-year horizon appears to be reliant on the premise that firms and workers cannot adapt to the realities of a world with COVID-19.

Peak Oil

One of the other issues with the inflation outlook is the question of oil prices. At the moment, wholesale energy prices have undergone a correction, which will blow a hole in the rate-of-change of the energy component of the CPI. On a longer horizon, we might need to be cautious.

As seen in the chart above, “liquid” production has peaked in the United States (right about when one of the more reliable contrary indicators on Twitter was laughing about Peak Oil). This was somewhat predictable: fracking generates output quickly, but the depletion rate is also rapid. The industry was unable to keep up the frenetic pace of drilling since it was not economic.

Admittedly, high oil prices could generate another burst of fracking activity. However, the reality is that the fracking needs to move towards more marginal sites, and depletion gets worse as conventional oil production continues its secular decline.

There are of course other sources of hydrocarbons. However, the United States was the epicentre of fracking triumphalism, and the most that oil production bulls can hope for is that the same script plays out elsewhere (horrifying anyone worried about climate change).

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(c) Brian Romanchuk 2021

The Great Inflation Scare Of 2021 (Or Not...)

We had a blowout CPI print in the United States last week, which I probably should have discussed. Unfortunately for my writing productivity, I had some consulting work going as well as visiting family, so I did not have time to dig.

Since then, large numbers of electrons were spilled online discussing the inflation outlook. As I doubt that I will add any details that are novel at this point, I have decided to bow out of that discussion. Instead, I will just offer a few generic observations.

The first thing to note is that forward breakeven inflation rates (as calculated by the Federal Reserve) have risen since the pandemic lows — but are still not above the levels seen in the early 2010s. (As a technical note, one might be able to fine tune breakeven inflation calculations with access to security-level data. But the Fed H.15 data is perfectly adequate for a big picture chart like the one above.)

We need to use forward inflation since everybody accepts that there will be a run of punchy inflation data over the coming months. How long the “punchiness” lasts is the topic of heated debate. As a non-forecaster, I am staying out of that debate. That said, the TIPS market indicates that the punchiness subsides within 5 years. Say what you want, that is not exactly a secular shift in inflation pricing.

Could technicals influence the forward? Sure. The problem is that the most important technical is the demand for inflation protection by the private sector, which is really only counter-balanced by TIPS supply. If people were really worried about inflation, they would be bidding up protection versus fair value — the breakeven ought to be biased higher versus “true” expectations. If that were the case, then the “true” expectations are not elevated relative to “target” (which is vaguely defined at this point).

So unless we are convinced the market is wrong — and it could be (you pays your money, you takes your chances) — the inflation story is just about the timing of “transitory.” Even without digging into data, it seems clear to me that we need to get the flurry of holiday spending out of the way before we can see what the underlying supply chain status looks like.

The other angle is wage inflation. I think we have seen some unsustainable business models based on the availability of desperate workers, and/or hoodwinking people who were unable to account for depreciation into being “contractors” have finally hit the end of their sustainability. Such business are going to face higher wage costs. It remains to be seen whether this is a one-off shift, or sustains itself.

In any event, I hope to return to my inflation manuscript later this week. My feeling is that it will make sense to hold off finishing the book until after we see the backside of this inflation wave (or not), so if I get the bulk of the text sketched out, I will then let the text rest for some months.

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(c) Brian Romanchuk 2021

Trillion Dollar Coins And Debt Ceilings (Again...)

The periodic debt ceiling silliness has again erupted in the United States. Since I was feeling mildly unwell this week, I was largely out of the loop. If the reader wants a brief explanation of what the trillion dollar coin idea is about, I highly recommend my brief discussion in my latest book Modern Monetary Theory and the Recovery.

If we go beyond the shameless self-serving plugs, it is quite easy to summarise my views.

Slicing And Dicing The CPI

The latest CPI report showed a spike in the core measure (excluding food and energy). The core inflation rate has hit a modern record, which has prompted mutterings about monetary debasement in certain quarters of the internet.

The reason why economists look at core inflation is that they want to see the underlying trend. However, stripping out food and energy is not the only way to do it. An alternative technique is to take the median change each month (or strip out the extreme changes). The Cleveland Fed calculates a median CPI series, which was also updated today. Although the monthly change did rise in the latest month, if one creates an index based on the monthly changes, the median CPI is just recovering from a plunge in 2020 (black line in the figure above).

It is entirely reasonable to be unhappy with economists who strip out all the rising prices from price indices to argue that inflation is contained. That said, the median CPI did a decent job of capturing the underlying trend in the modern era, unlike the erratic All Items (headline) CPI measure (red dotted line).

I am biased towards the recent rise in prices being largely transitory, but I am not attempting to forecast inflation. I think the direction of wages will matter than the prices of goods and services. Wage costs have risen, but I am unconvinced that there has been a major structural change in the balance of power between workers and employers.

(Note: I may expand these comments about the median CPI as a book section, but that will take time to appear.)

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(c) Brian Romanchuk 2021

Belated U.S. Jobs Data Comment

I just wanted to make some generic comments on the latest U.S. jobs data that came out last week. My comments are somewhat delayed as I was somewhat groggy from vaccine side effects over the past few days. Although there was some divergence in the data, I tend to look at underlying trends, and those seem to be in a positive direction.

Matthew C. Klein also recently joined Substack, and wrote a lengthier piece on it. If the reader has not already gone through the details of the report, Matthew’s piece is a good place to start.

I will largely not comment on what he wrote, other than the big point he notes: there was a divergence between the Household and Establishment job growth numbers.

Inflation Monitoring Comments

I was asked about the commentary in a report "Inflation, Do You Feel it Yet?" by the Interprime Newsletter. I think it follows standard market research conventions, which is aimed to be fairly sensitive to changes in direction. The problem with this sensitivity is that underlying inflation in recent decades in the developed world is quite sluggish. However, as seen in the chart above, standard economic time series have been mangled by the economic disruptions associated with the pandemic.

U.S. Economy Getting Better, But...

Although I expect to see fairly impressive rates-of-change in economic variables over the coming months, levels matter as well. Under normal circumstances, the economy is relatively close to its steady state glide path, and the fixed income market is quite reasonably jittery with respect to the latest growth rates. (I would argue too sensitive, but people who are paid to stare at lines all day generally want to make the backstory about those lines as exciting as possible.)

The Implausibility Of The Chapwood Index

The Chapwood Index has become a popular source to cite by hard money proponents who are pushing the line that inflation is really much higher than what government statisticians suggest. It has taken over the limelight from Shadowstats, which pioneered pushing that particular line. Although it is entirely expected that individuals can face cost of living increases that rise faster than official the CPI inflation rate, the levels of inflation suggested by the Chapwood Index do not appear to offer any plausible information about the price level as the concept is used into macroeconomics.

Update 2021-02-21: If one searches for “Chapwood Index” on a few search engines, this article shows up, but not the Chapwood Index itself. My link is broken. I think what has happened is that they have attempted to pivot to chapwoodindex.org. There’s a site at that URL, but in terrible shape. The text quoted here may not appear on that site.

Fed Rearranges Deck Chairs On Monetary Policy Titanic

The Federal Reserve has announced some changes to its description of the long-term objective of policy (link). From an operational perspective, this change is entirely cosmetic, and accomplishes nothing useful. It is really a distraction from the reality that the Fed is pushing on a string. The only way forward for monetary policy is for it to be transformed into fiscal policy.

Update: The World's Simplest Bond Model

I ran across a comment to the effect that Modern Monetary Theory (MMT) somehow is missing a theory of interest rates. Given that the MMT description of interest rates is that it is driven by expectations, and that my view is that this is the most solid way to understand interest rates, I was slightly annoyed.

First Wave Of Disastrous Real Economy Data

U.S. labour marker data for April was released, and it was ugly, which should be a surprise to nobody. If we step back from considering the human costs of this downturn, the chart above demonstrates that a lot of data has lost information value courtesy of the nature of the pandemic. As shown, measured hourly wages for non-supervisory employees has risen by the most since the early 1980s. Since people like myself often used this time series as a measure of inflationary pressures, this would be concerning. The reality is that this rise is just an artefact of the reality that low-wage jobs have borne the brunt of layoffs or furloughs.