This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.
A recent Barron’s poll was conducted among money managers.
This poll was about the biggest perceived risk to stock markets over the next 12 months.
- The Barron’s poll indicated 20% are most worried about rising interest rates.
- The runner-up (at 16%) was COVID case resurgence, perhaps from new variants of the virus. This change in leadership is not surprising, one might say. Factor in relatively fast vaccination distribution since the end of 2020, and signs U.S. state policy-makers are getting close to full re-openings. The overall economy is running on all cylinders again.
- Consumer Price Inflation only came in at the 4th spot (at 11%). Complicating matters, one might correctly argue. CPI risk is very closely related to rising interest rate risk.
The decline to 2nd place by Covid-19 in the ranking appeared obvious to us. Albeit, it is not a safe bet, we might highlight: an irreversible conclusion to the domestic pandemic saga is not in the bag yet, and a global calamity is still underway.
Rising rate risk worry appears somewhat less straightforward to us. That is, a lot has to happen over the next few quarters for that risk to materialize. Particularly, given the fact both formal and informal communications by FOMC voting members have been very clear over the last few years. They project scant chances of any policy interest rate increase.
In order to ascertain interest rate risk, introduced by a change in policy on the short end by the Fed, we need to understand consumer price inflation dynamics. We need to take a closer look under the hood. And gauge -- to what degree – the Fed might indeed see an inflation spike over the coming months.
The version of consumer price inflation the FOMC focuses on, the Personal Consumption Expenditure (PCE) Core Inflation Index, shows very few signs of any sustainable increases, leading to a broadening increase in everyday price inflation.
That aggregate demand, macroeconomic accounting-related indicator is very unlikely to pick up on a number of internal market developments. Nonetheless, these are going to be unfolding over the next few months, in our view.
Consult the following chart, to fully grasp the Fed’s PCE timeline perspective.
U.S. Personal Consumption Expenditures (ex-Food & Energy) 2007 to 2021
An important point to make to all of you: This measure of consumer price inflation is not without its flaws. It has been criticized over the years for not measuring inflation accurately.
That being said, economic models have a long history of being accused of not being a close depiction of reality. Economists will reply that they are not meant to be, but rather help to understand certain relationships.
Measurement of inflation — by central banks — qualifies as one of those examples. Government Economists simplified reality by excluding food (starting in the 1950s) and energy prices (starting in the 1970s), as they are typically exposed to market forces outside of the control of central banks. Policy measures won’t be as effective against a measure of prices that includes these.
In fact, food prices have surged +7.8% year to date in 2021, as measured by the FAO Food Price Index. Commodities overall are up 20% year to date in 2021, and almost recovered back to pre-pandemic levels as indicated by the Commodity Research Bureau Index (this has a 41% weight given to agricultural products).
Meanwhile, another area affecting consumer perceptions of inflation is housing. Since the beginning of the pandemic last March, the S&P/Case-Shiller U.S. National Home Price Index witnessed a new record for home prices. That Home Price Index increased +12% from just a year ago. Such a stiff annual increase definitely reached the top decile of historical home price acceleration rates. Consult the next two charts to confirm this yourself.
S&P/Case-Shiller National Home Price Index (1 Year % change, 1990 to 2021)
.jpg)
With the national home sales prices growing at this rate (shown above), it is no surprise.
The U.S. home buying market has easily surpassed its highs reached prior to the 2007 subprime crisis (shown below):
S&P/Case-Shiller National Home Price Index (Jan. 2000 = 100, 1990 to 2021)
However, the Fed does not consider housing a consumption good. But rather an asset. Their equivalent consumer inflation proxy is so-called owner’s equivalent rent. Owner’s equivalent rent makes up roughly 1/3 of core PCE, and this monthly rent proxy is showing a mere +2.0% change from a year ago: See that below.
Owner’s Equivalent Rent of Residences in U.S. City Average (1984 to 2021)
To be clear, we absolutely agree with the approach the FOMC is taking, in terms of focusing on a measure of inflation affected and driven by its old-school monetary policy variable: the short-term Fed Funds Rate. And frankly, PCE “expectations” are reflected within the current long-term U.S. Treasury rate markets, which are set by bond traders, independently.
Excluded variables such as food, energy and housing prices are affected by a wide array of market forces. The Fed Funds Rate remains a poor tool to manage these factors.
Yet since 2008, the FOMC has stepped in and bought long-term Treasury and mortgage-backed bonds. Every month at the NY Fed. They are in the housing game now, forever.
The Fed’s founding statutes were first written in 1913. The 1933 Banking Act created the FOMC, which now oversees open bond market operations. A later amendment required the Federal Reserve "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Those are statutory goalposts in play now.
So, history shows us. Times do change Federal Reserve policy frameworks. But only over decades. The old-school CPI measuring frameworks, informed by the events of the 1950s to the 1970s, do not reflect post-2000 and post-2008 Wall Street market structures.
So, given the measure of consumer price inflation currently used by the Fed show very few signs of inflationary pressures, we remain confident.
The risk of a compelling short-term statutory policy rate intervention — in terms of higher interest rates — remains low. Tapering the bond purchasing is another question altogether.
If the major market variables — that are kept out of the core inflation measure — come back in through the backdoor?
We might have a problem.
Recall.
Inflation is not simply a monetary phenomenon (our apologies to Milton Friedman).
That is, the amount of money (M1, M2, M3) in circulation is only one driver of consumer price inflation. That simple theory is MV = PY, if you open an old macro textbook.
Other key drivers are long-term, multi-year, inflation “expectations,” built up by market participants. Unless aggregate price changes (the P) are substantial multi-year events, and not just transitory, individuals typically do not change those long-term “expectations.”
It thus depends, in our view, to what degree accelerating and unstable spiky price factors -- those that are ignored by the FOMC’s Fed Funds policy-making apparatus, but worked by its “QE” monthly bond-buying -- remain just noise to those bond market “expectations.”
Since they aren’t here to stay.
Infrastructure Stock Boom to Sweep America
A massive push to rebuild the crumbling U.S. infrastructure will soon be underway. It’s bipartisan, urgent, and inevitable. Trillions will be spent. Fortunes will be made.
The only question is “Will you get into the right stocks early when their growth potential is greatest?”
Zacks has released a Special Report to help you do just that, and today it’s free. Discover 7 special companies that look to gain the most from construction and repair to roads, bridges, and buildings, plus cargo hauling and energy transformation on an almost unimaginable scale.
Download FREE: How to Profit from Trillions on Spending for Infrastructure >>
Image: Bigstock
Is the Fed Still Measuring Inflation Correctly?
This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.
A recent Barron’s poll was conducted among money managers.
This poll was about the biggest perceived risk to stock markets over the next 12 months.
The decline to 2nd place by Covid-19 in the ranking appeared obvious to us. Albeit, it is not a safe bet, we might highlight: an irreversible conclusion to the domestic pandemic saga is not in the bag yet, and a global calamity is still underway.
Rising rate risk worry appears somewhat less straightforward to us. That is, a lot has to happen over the next few quarters for that risk to materialize. Particularly, given the fact both formal and informal communications by FOMC voting members have been very clear over the last few years. They project scant chances of any policy interest rate increase.
In order to ascertain interest rate risk, introduced by a change in policy on the short end by the Fed, we need to understand consumer price inflation dynamics. We need to take a closer look under the hood. And gauge -- to what degree – the Fed might indeed see an inflation spike over the coming months.
The version of consumer price inflation the FOMC focuses on, the Personal Consumption Expenditure (PCE) Core Inflation Index, shows very few signs of any sustainable increases, leading to a broadening increase in everyday price inflation.
That aggregate demand, macroeconomic accounting-related indicator is very unlikely to pick up on a number of internal market developments. Nonetheless, these are going to be unfolding over the next few months, in our view.
Consult the following chart, to fully grasp the Fed’s PCE timeline perspective.
U.S. Personal Consumption Expenditures (ex-Food & Energy) 2007 to 2021
An important point to make to all of you: This measure of consumer price inflation is not without its flaws. It has been criticized over the years for not measuring inflation accurately.
That being said, economic models have a long history of being accused of not being a close depiction of reality. Economists will reply that they are not meant to be, but rather help to understand certain relationships.
Measurement of inflation — by central banks — qualifies as one of those examples. Government Economists simplified reality by excluding food (starting in the 1950s) and energy prices (starting in the 1970s), as they are typically exposed to market forces outside of the control of central banks. Policy measures won’t be as effective against a measure of prices that includes these.
In fact, food prices have surged +7.8% year to date in 2021, as measured by the FAO Food Price Index. Commodities overall are up 20% year to date in 2021, and almost recovered back to pre-pandemic levels as indicated by the Commodity Research Bureau Index (this has a 41% weight given to agricultural products).
Meanwhile, another area affecting consumer perceptions of inflation is housing. Since the beginning of the pandemic last March, the S&P/Case-Shiller U.S. National Home Price Index witnessed a new record for home prices. That Home Price Index increased +12% from just a year ago. Such a stiff annual increase definitely reached the top decile of historical home price acceleration rates. Consult the next two charts to confirm this yourself.
S&P/Case-Shiller National Home Price Index (1 Year % change, 1990 to 2021)
.jpg)
With the national home sales prices growing at this rate (shown above), it is no surprise.
The U.S. home buying market has easily surpassed its highs reached prior to the 2007 subprime crisis (shown below):
S&P/Case-Shiller National Home Price Index (Jan. 2000 = 100, 1990 to 2021)
However, the Fed does not consider housing a consumption good. But rather an asset. Their equivalent consumer inflation proxy is so-called owner’s equivalent rent. Owner’s equivalent rent makes up roughly 1/3 of core PCE, and this monthly rent proxy is showing a mere +2.0% change from a year ago: See that below.
Owner’s Equivalent Rent of Residences in U.S. City Average (1984 to 2021)
To be clear, we absolutely agree with the approach the FOMC is taking, in terms of focusing on a measure of inflation affected and driven by its old-school monetary policy variable: the short-term Fed Funds Rate. And frankly, PCE “expectations” are reflected within the current long-term U.S. Treasury rate markets, which are set by bond traders, independently.
Excluded variables such as food, energy and housing prices are affected by a wide array of market forces. The Fed Funds Rate remains a poor tool to manage these factors.
Yet since 2008, the FOMC has stepped in and bought long-term Treasury and mortgage-backed bonds. Every month at the NY Fed. They are in the housing game now, forever.
The Fed’s founding statutes were first written in 1913. The 1933 Banking Act created the FOMC, which now oversees open bond market operations. A later amendment required the Federal Reserve "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Those are statutory goalposts in play now.
So, history shows us. Times do change Federal Reserve policy frameworks. But only over decades. The old-school CPI measuring frameworks, informed by the events of the 1950s to the 1970s, do not reflect post-2000 and post-2008 Wall Street market structures.
So, given the measure of consumer price inflation currently used by the Fed show very few signs of inflationary pressures, we remain confident.
The risk of a compelling short-term statutory policy rate intervention — in terms of higher interest rates — remains low. Tapering the bond purchasing is another question altogether.
If the major market variables — that are kept out of the core inflation measure — come back in through the backdoor?
We might have a problem.
Recall.
Inflation is not simply a monetary phenomenon (our apologies to Milton Friedman).
That is, the amount of money (M1, M2, M3) in circulation is only one driver of consumer price inflation. That simple theory is MV = PY, if you open an old macro textbook.
Other key drivers are long-term, multi-year, inflation “expectations,” built up by market participants. Unless aggregate price changes (the P) are substantial multi-year events, and not just transitory, individuals typically do not change those long-term “expectations.”
It thus depends, in our view, to what degree accelerating and unstable spiky price factors -- those that are ignored by the FOMC’s Fed Funds policy-making apparatus, but worked by its “QE” monthly bond-buying -- remain just noise to those bond market “expectations.”
Since they aren’t here to stay.
Infrastructure Stock Boom to Sweep America
A massive push to rebuild the crumbling U.S. infrastructure will soon be underway. It’s bipartisan, urgent, and inevitable. Trillions will be spent. Fortunes will be made.
The only question is “Will you get into the right stocks early when their growth potential is greatest?”
Zacks has released a Special Report to help you do just that, and today it’s free. Discover 7 special companies that look to gain the most from construction and repair to roads, bridges, and buildings, plus cargo hauling and energy transformation on an almost unimaginable scale.
Download FREE: How to Profit from Trillions on Spending for Infrastructure >>