Inflation is relative

Alright?

Some people are ecstatic, some in disbelief, some unsurprised...

Mixed feelings all around, just like markets, always.

But the difference is that the stakes are probably a bit higher than previous times, what with everything costing a shitload more and talking heads on Twitter forgetting the real world consequences of these numbers we look at on our screens.

I still don't understand how people on ÂŁ30,000 living in major cities are surviving through this, and I feel greatly for them.

This is always forgotten as we discuss asset prices, which the majority of people are priced out of buying.

I wanted to hark back to the piece that the living legend Tim wrote a while ago...

Because this is at the heart of what many were talking about yesterday.

Example, look at this misunderstanding from a huge Twitter account...

 BIDEN: WE HAVE 0 PERCENT INFLATION (actually, +8.5%)pic.twitter.com/XZHE8bC9Fd— The_Real_Fly (@The_Real_Fly) August 10, 2022 

Biden is absolutely correct.

For July, inflation was at 0%.

YoY, it was +8.5%.

This is not contentious, wrong, a mis-speak, nothing.

The Real Fly is just flat out wrong.

What this 0% MoM number hides is that it was only headline that was 0%.

Core was still +0.3% with expectations of 0.5%.

So the market has had a bullish reaction off a miss vs expectations - good for traders, but not making much difference to the everyday person...

And what we have to remember is that the Fed also looks primarily at PCE (Personal Consumption Expenditures) Inflation, which comes at the end of the month.

But my point here is that inflation is still high - what if next month we get a print of 8.6%?

Most of the headline inflation decrease leading to the 0% number came from the decline in gas prices...

But check out RBOB futures.

Bounce in August...

The weakness came through July as you can see from the chart.

So people having a nice early parade around inflation coming down might need to pay attention to this metric considering it was the input leading to the decline.

Airline fares also dropped 8% contributing to the decline...

This is in a way backed up by the inventor of inflation swaps.

He says...

As an aside, to me this still looks low. There should be asymmetry to outcomes (5% higher inflation is more likely than 5% lower inflation) that implies these should have some option value and trade above our raw expectations for inflation’s path. Still, it’s not horrible.

Although I think the 3.7% for the next 1y DOES look quite low. We’re at 6%-ish right now on both core and median. It isn’t just one thing that needs to revert to some mythical mean. It’s the whole dang distribution. That seems challenging.

Michael Ashton goes on to say (and you can read the full piece here, but it's rather long)...

And the bigger picture is this: the economy is headed into a recession, but the signs on that will be unclear and/or people will be able to explain the signs away for a while. Meanwhile, inflation remains high and sticky, despite today’s number. I’m pleased that median CPI, which  exploded to 0.7% m/m in June, was back down to “only” 0.53% or so in July. But that’s still a 6.4% rate, and looking over the last several months you certainly can’t say there are any signs that inflation pressure is lessening or narrowing. At best, leveling off…and it’s even too early to be sure about that, given the continued acceleration in rents.

A year ago, I would have said that the Fed will take advantage of the weaker inflation data to back off of tightening some. But the Fed has been far more hawkish than I expected, and if they really do want to “get ahead” of inflation then they need to do it sooner rather than later since once core inflation starts to drop because of base effects, and the employment situation starts to weaken, there will be much more resistance to 75bp hikes. If Unemployment is at 5% and rising, they will not be hiking 75bps per meeting, no matter where inflation is.

So I’d repeat my admonition above – be careful jumping on board this equity rally. If stocks can sustain above 4200, then I have to reluctantly go along with the momentum. But I’d be careful about being too excited about inflation just because airfares dropped 8% this month.

I'd agree with his take here.

And specifically on airfares...

If airfares have a large weight and the prices have dropped, we can maybe suggest that prices have dropped due to lack of demand.

And lack of demand is probably due to other things becoming more expensive, so fewer people are buying bloody plane tickets!

So we must ask about the weight given to airfares in the basket.

I'm not going to go down that route since I just want to nail in the concept of how we should think about the relative changes in inflation when looking at the changes in the basket.

Let's step away from the specifics of the inflation side of things and make a point more generally.

Inflation is high and is sticky.

A point I have made for a while now is to do with the zero lower bound.

You can find my thoughts on this in the below piece.

Specifically in this piece, I referenced a paper describing the effects that operating at the ZLB has on an economy.

I'll requote it...

An important finding from our model is that uncertainty rises when the policy rate comes close to or hits its ZLB. Why does this happen? The Fed has a dual mandate to stabilize prices and maintain full employment.

When the Fed is not constrained by its ZLB, it responds to unexpected negative economic events by reducing its policy rate, which dampens the effects of the lower demand. In situations when the Fed is constrained, like it was during the 2008 financial crisis, additional rate reductions are no longer possible. As a result, the economy becomes more sensitive to further declines in demand, which leads to lower real GDP than if the Fed was unconstrained.

Uncertainty rises because people have more difficulty predicting future economic outcomes. Away from ZLB, the Fed is able to help stabilize the economy, so the range of plausible forecasts is relatively narrow. When the Fed loses that ability due to the ZLB, output is more sensitive to shocks that hit the economy so the range of forecasts is much wider.

This therefore means that the Fed is looking at getting rates higher and probably extend past the neutral rate under the guise of inflation (or at least, coupled with).

Bottom line: it is in the Fed's interest here to push rates as high as possible, given also their desire to shed the balance sheet which is a bit of a storm in a teacup...

I'm not going to explain this myself, so I will drop you ANZ's note on it...

Effectively, this note suggests that the next big issue will be liquidity withdrawal, not interest rates, which will affect risk assets in a relatively broad sense.

So the conversation is likely to flip from rates to more complex shite that I only just understand to do with the balance sheet and the Treasury General Account.

The one key quote to pay attention to though is the following...

From a macro-risk-complex perspective, QT-complacency risk will fade quickly as the prospect of -ve Net $-Liquidity will keep financial-conditions tight. The RoC-risk is skewed to further tightening and as such we believe that risk-assets remain vulnerable to another leg lower, at-least from this perspective.

This is all going to be occurring heading into December - and all parts of liquidity are set to be net negative.

I believe I had spoken previously of people being very short termist in their thinking, and where risk assets are currently would suggest that there is a massively premature view the Fed will pivot, given the other part of the tightening equation which is the balance sheet and TGA side - the Fed Funds rate is just one part; a big part of course, but still just one part.

In August last year, I had the same view as I have now...

That we should be mindful that turbulence will crop up again over the next few months, but I would not be surprised to see the ES at 4300 before that turbulence hits!