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.”