The word of the day

Tuesday, June 12, 2007

Readers of a certain vintage and nationality may recall the “Mr. Robinson’s Neighborhood” sketch that a young Eddie Murphy used to perform on Saturday Night Live in the early 1980’s. The sketch, a takeoff on a popular children’s television program, used to feature a “word” of the day, which normally landed Mr. Robinson in trouble. In the spirit of those old SNL sketches, today’s word is “inflation.”

Today say the release of May CPI in China, which registered a higher-than-expected rise of 3.4%. This was the highest reading in two years. Most economists immediately shrugged it off, noting that the bulk of the rise is attributable to food prices, which rose 8.3% y/y. In contrast, non-food CPI was only up 1% y/y. The question that Macro Man cannot get out of his head, however, is the following: don’t Chinese workers need to eat? And as they become more affluent, won’t they eat more expensive, protein-based foods? Won’t this ultimately play a factor in raising wages in China and, ultimately, unit labour costs, which will raise the cost of export prices?
In Japan, meanwhile, McDonald’s has announced the intention to raise prices in a thousand urban stores to meet rising rent and labour costs. While they are also adjusting prices downwards in some rural locations, the aggregate impact will very much be one of higher prices. All this comes on the heels of a rise in the price of a bottle of plonk. Perhaps 10 year JGBs won’t stop at 2%, as is commonly supposed. (Note that Macro Man rolled his JGB futures short yesterday.)

In Europe, ECB President Trichet gave a speech wherein he noted that the Bank takes asset prices into account in making policy. The rationale, he explained, is that the ECB believes that asset-price inflation impacts consumer prices. Paging Alan Greenspan....

Friday sees the announcement of May CPI in the US, and the Fed will probably pat itself on the back if and when core prints another 0.2% m/m and 2.3% y/y. Who knows, maybe the owner’s equivalent rent, a measure that reflects the consumption basket of nobody, will push it even lower. Ignored in all this will be another tasty rise in the headline CPI, which is forecast to rise 0.6%. This would represent the fourth monthly rise in the unadjusted index of 0.5% or more this year, and take the year-to-date rise in CPI inflation (that is, the rise since December) to 3%. This is the inflation rate being faced by Mr. and Mrs. Joe Sixpack, not the core measured favoured by the Fed.

In fairness, the core measure should provide an anchor for headline inflation during periods when volatile commodity prices are mean-reverting. However, this is not currently the case, as a cursory glance at any commodity index chart covering the past five years will attest. As a result, there has been a persistent gap between the trend of headline and core inflation this decade. The last time such a gap opened up with such persistence was in the 1970’s. The driver of the gap, unsurprisingly, has been commodity prices: trend changes in the CRB have a remarkable correlation with the trend in the gap between headline and core CPI.

As long as the Fed continues to focus on core prices, which strip out the rising trend in food and energy, the actual cost of living in the United States is likely to remain uncomfortably high, and inflation expectations (which are formed by real-world cost of living rather that constructs such as owner’s equivalent rent) will remain firm. Therein lies the trade (which Macro Man admittedly already owns.) TIPS appear to be priced on the basis that the Fed will be broadly successful in reining in core inflation, and that headline will follow suit. As long as the commodity bull remains in place, however, that is unlikely to occur on a trend basis.

Consider that for most of the past 20 years, the basis between core CPI and core PCI has trended between 0.25% and 0.75%. It is currently near the bottom of that range and is trending wider. Then consider the chart above, which suggests a “fair” medium term spread between headline and core CPI of 0.6%. Add them together, and you get a trend basis spread between headline CPI, off of which TIPS are priced, and core PCE, the Fed’s ostensible inflation target, of roughly 1.1%. If this basis holds (and it is more than doing so at the moment), then even a return to the 1.75% core PCE target would imply a trend headline CPI rate of 2.8%-2.9%. When you compare that to what’s being priced at the moment, TIPS look like a great long-term value, and will continue to do so until the word of the day changes to “headline inflation.”











Posted by Macro Man at 10:53 AM  

11 comments:

i got this feeling of something terribly wrong... when saw pork prices in china post 40+% increase in a year... this is not something one can iron out without turning every piece of equipement off...

Anonymous said...
11:51 AM  

It's amazing what you learn when data prints an unfriendly figure. Who knew that there was a porcine malady called "Blue Ear Disease" or that China has a Strategic Pork Reserve until today? I suppose we shouldn't be surprised that prok prices are rampant; it is, after all, the Year of the Pig.

Macro Man said...
12:58 PM  

My own skewed PA cash-position is predicated on the fact that we've been walking the ridge-line between inflation and deflation for the better part of two-and-half-years. In recent (post Volcker) years, the steepness of the slopes (the opportunity cost of having wrong allocation) has resembled the soft hills of the Appalaichans, but since 04, when real rates were pegged negative, and US bond market was neutered, the steepness has been increasing. Now, an inflationary allocation when the pendulum swings back towards deflation will be lethal, and likewise, the deflatonary portfolio of long-duration FI will diminish towards oblivion as inflationary expectations rise.

Calling which side of the ridge-line we eventually descend, has been tough, though my cornerstone thought has been that political spinelessness will ultimately lead to demagoguery and inaction and so cause us to slip down the inflationary slope. When the market understands this becoming popular wisdom (and so overwhelms even the mighty Voldemort) the market will do what authorities couldn't and wouldn't countenance.

Growth, and muted goods-price rises, rising productivity, and generally full-employment have acted as a "squelch" upon the rather obvious inflationary signals evident to all who desire to observe.

Higher taxes in US, and higher rates in CHina & USA would have long-ago sorted the problem, leaving the slopes less steep, and the recession but another under brush-clearing recession.

The restraint upon market forces this time, has created a massive build-up of monetary reserves, credit, and diverged asset prices and potential inflation far from a stable equilibruim, unless reserve accumulators take their booty and stuff it under the mattress until maturity while US sorts out fiscal and energy mess. Neither seems likely and so the financial "entente cordiale" will burst and the inflation pendulum will continue to stoke inflationary expectations driving the market (through rates) to absorb/destroy the liquidity /credit that authorities have been too timid to act upon.

"Cassandra" said...
1:20 PM  

The food inflation come from the USA ethanol program wich drove the corn price higher. This time the energy inflation has transformed in food inflation...

As long as oil price keep going higher the food price is going to climb togheter.

Anonymous said...
1:26 PM  

plonk indeed. but did you see burger king is back in the game in japan? perhaps that's just as inflationary, or reflationary.

short JGB futures? hmm. just watch for that short-covering snap-back. you know those japanese institutional/postal accounts are just waiting to pull the trigger...

tmcgee said...
1:39 PM  

Your point about the importance of headline inflation is well taken, but I am beginning to wonder if interest rate hikes are really the right tool for food price inflation. Now I have not read any research to support the following claim, but I would imagine that demand for foodstuffs (especially perishables like meat and dairy) is pretty inelastic. Thus, a central bank can throw on the brakes but food demand will be the very last thing that takes a hit. Also, the current run up in food prices seems to be more of a supply issue with the US/Australian drought, new demand for corn for ethanol in the US, and various other idiosyncratic factors reducing the supply of food. Perhaps its better for everyone to have their own 'strategic pork reserve' to cushion leads/lags in production...

Taking a more broad view of commodities, do you think it would be acceptable to G3 governments if their CBs trashed their economies to balance out excess oil demand from China and India?

Anonymous said...
1:41 PM  

maybe for as much as it's ridiculed, japan's core inflation excluding fresh food but including energy might make sense then (as not being the uber-ignorant core)...

tmcgee said...
1:51 PM  

Tim- yes, we are entering dangerous territory for a JGB short. But the expectation on insitutional demand at 2% is so widespread, I just wonder if we won't overshoot a bit first, so I am going to give it the benefit of the doubt.

Anonymous, I'd agree that there is little the Fed or anyone else can do to control food and energy price inflation in the near term. (Enginerring a recession would do a good job of lowering those prices, one would suspect.)

However, to blithely ignore those prices, which represent a substantial component of the cost of living, in a quest for 'price stability' will almost certainly generate a false confidence in the ability to stabilize prices, perhaps ultimately leading to the sort of outcome that Cassandra describes above.

Moreover, if one believes that energy and food inflation is a result of globalization and the economic rise of BRICs, and thus should be stripped out as an exogenous factor, shouldn't all (disinflationary) imported goods and service prices also be stripped out as exogenous? Trichet has made the claim in the past that you cannot include the 'good' bits of globalization without also taking the 'bad' bits into account.

The Fed might not reach a headline CPI target of, say 3%, just as the ECB, MPC, RBNZ, et al have broadly failed to meet teir targets over the last few years. But at least the Fed would win back a bit of credibility by at least targeting a measure that bears some resemblance to the cost of living.

As long as the Fed focuses on narrow measures, I think the TIPS 'arb' is likely to work.

Macro Man said...
1:53 PM  

If only it were just a food-price issue. But its not. Bottlenecks and cost-push are everywhere (even labour excepting all the most desperate, unskilled,or geographically-challenged of workers). The Postal workers are on the verge of industrial action in London over pay (despite 40,000 layoffs in recent years - that's ballsy!) and the refuse collectors where I live (as well as Naples) have let the garbage pile up as a demand for higher pay. It will be fascinating to see what happens in France when the much larger public-sector put their demands for higher pay to Mr Sarkozy.

Inflation will be on the cover of BOTH Time, and The Economist before summer's end.

Now, about that very large short-gamma pocket somewhere above 5.5% on the longbond......

"Cassandra" said...
1:59 PM  

1) I love gamma. Mmm, tasty gamma.
2) Inflation? Deflation? C'mon, kids, cite the numbers. Nothing, but nothing, points at a real, broad price rise -- or fall.
3) back to #1. I recently picked up a new contract, and in the interim my whatever-I'm -getting-paid positions are doing so well I regard them with great suspicion.

wcw said...
6:55 AM  

Gamma is indeed lovely, providing you can escape the clutches of its evil twin theta.

As for evidence of inflation: food prices in China are up 8.3% y/y. US import prices from China are now up y/y for the first time since the series began. Perhaps it's a coincidence. Then again, perhaps not.

Food and energy prices globally are rising at a pace well above the trends of the past 25 year, at a time when secular demand for food and energy from the heretofore-disenfranchised billions is rising faster than the global economy's capacity to produce these items. If that ain't inflationary, what is?

Macro Man said...
7:40 PM  

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