Thursday, November 17, 2016

October 2016 Inflation

I am a bit frozen in place as to whether we are looking at a bullish continuation or a bearish turn.  Rising treasury yields are a good sign, both because they suggest an improving economic outlook and because they imply a passive loosening of monetary policy in a way that the Fed seems not to usually counter in real time.

On the other hand, the inflation doomsday scenario is building, as the Fed talks up rate hikes while non-shelter inflation falls to well below target.  I'm a bit surprised that long bonds have been as strong as they have been.

My suspicion is that we will tend to see a lot of sideways movement across asset classes and that sometime during 2017, yields will turn back down if the Fed continues to read shelter inflation as a monetary phenomenon.

The divergence between shelter and non-shelter inflation continues this month.  In five of the last six months, Shelter inflation has been over 0.3% and non-shelter core inflation has been under 0.1%.  The CPI now lists unadjusted year over year core inflation at 2.1%, consisting of 3.5% shelter inflation and 1.2% non-shelter core inflation.

A reminder that loyal readers probably don't need at this point - most shelter inflation is imputed and has nothing to do with cash transactions.  We are tightening monetary policy to counteract a price level that probably has little to do with monetary policy and much to do with supply.  Supply of this particular asset tends to react positively to monetary and credit expansion.  At this point, I don't think housing starts are particularly sensitive to interest rates.  But, inflation would be helpful in continuing to raise nominal home values and incomes, to help heal the damage we have wrought on the bottom half of the housing market and rebuild equity.  (Note, this isn't because rising prices are always good.  This is because prices where they currently stand are unusually low because we inflicted a credit crisis on the low end of the housing market that pushed implied yields on investment up for the few investors who could tap into the market.  Advantages of home ownership include both the natural advantages of control and arbitrary tax advantages.  The tax advantages largely accrue to the high end of the market, and control advantages accrue more strikingly to the low end of the market.  We have perversely created a post-"bubble" housing market that has maintained the high end tax advantage while undermining ownership at the low end, and this is reflected in relative prices.)

If homebuilding drops a bit, it will be blamed on rising interest rates cutting into demand.  I declare this, pre-emptively, to be a spurious correlation.  That actually gives me some hope, because if the regulatory obstructions to mortgage lending can be loosened a bit, then in this battle between the neutral rate and the inadvertently hawkish Fed, the neutral rate might have a chance to get out ahead of the curve, and then I think we would see rising interest rates, an accelerating homebuilding market, and a rejuvenated recovery.

As a speculator, I think it would be easier to position for a predictable Fed over-reach, but as a citizen, I'm pulling for the more complicated potential for a recovery, despite ourselves.


  1. Gadzooks, this is a great post.

    OT but not:

    This problem of property zoning leading to higher house prices, leading to exposed banking systems, is global.

    Amazingly, scarcely written about.

    1. Thanks Ben.

      Interesting article. I wonder what all the reasons might be for the high P/R levels. I wonder if a lack of renters rights laws could cause P/R to be higher in high demand Chinese cities than in the US. I don't know. Just spit-balling.

  2. The authors mention zoning and even mention SF NY.

    At the risk of sounding like a Johnny One Note, I think so much of real estate discussions come back to zoning lack of free markets.

  3. Regarding bond yield, is there any reason to explain the rise which started even before the election? could it be someone know for sure that Trump will win and sold bond to buy old economy stock? or China is selling to defend RMB (but China Treasury holding dropped by 20B only which should not be significant in this market). If China Forex reserve holding dropped another 200B this year, which is likely, do you still think the bond yield can turn back down?

    1. I'm afraid I don't have any insight into those factors.