5 Views of Inflation v.2

The CPI was released today. Here's an update.



Not much to see in the three month chart. It's been relatively tame lately. I doubt the rising price of oil and falling dollar will be kind to it in the near-term. Who knows though? Christmas might be looking a bit ugly.



Not much to see in the six month chart. Inflation is running a bit warm but might have some favorable comparisons soon.



The one year chart is now lined up perfectly with last year's commodity selloff. We apparently didn't get one this year. Trend line, you lose! Oh well! You can't trust them anyway. They are just lines after all.



The two year chart is now lined up perfectly with Katrina's aftermath two years prior. Trend line, I therefore suspect you might be losing too soon. (Note to self: stop talking to the trend lines.)



Okay, now this is the one that concerns me. Inflation trends and the expectations that go with them (once established), are a "bear" to break. All the rest is just fluff to me.

See Also:
5 Views of Inflation
Trend Line Disclaimer

Source Data:
Consumer Price Indexes (CPI)

Retail Sales

The shaded area represents our last economic contraction.

This chart shows retail sales excluding gasoline stations, food and beverage stores, and food service and drinking places (per capita and adjusted for inflation).

The trendline is a 4th order polynomial and simply represents what my eyeball seems to see.

It continues to look like it is rolling over to me, for what that's worth.

See Also:
Retail Sales (2000 to Present)
Trendline Disclaimer

Source Data:
U.S. Census Bureau: Monthly Retail Sales
St. Louis Fed: Population: Mid-Month
St. Louis Fed: Consumer Price Index For All Urban Consumers: All Items
BLS: Consumer Price Index
National Bureau of Economic Research, Inc.

BOE Embraces Sharp Slowdown and Higher Inflation Theory

Bank warns of economic slowdown
In its first report since the August credit crunch, the Bank says it expects a sharp slowdown in UK domestic growth in the next year - and higher inflation as well.

That's stagflation, right?

The governor refused to call the situation stagflation, which is the combination of a recession and high inflation, saying things were much worse in the l970s when rising oil prices and spiralling government spending pushed the UK economy deep into recession.

Refuse to call it stagflation while bringing up 1970s rising oil prices and spiralling government spending? Fantastic plan!!

Illusion of Prosperity, attempting to maximize economic sarcasm on the Internet since 2007.

Close Encounters of the Fear Kind

Let's say I have some money and I wish to earn interest on it.

If I am greedy, I might choose to lend it to someone for 30 years so that they can buy a house. There are obviously many risks here (potential rising inflation, getting paid back, and so on). The lower the interest rate I choose to accept (to offset those risks) the more greedy I am.

If I am fearful, I might choose to lend it someone with a printing press so that they can always pay me back. I could offset some of that risk by not lending them for very long periods (say three months at a time). The lower the interest rate I choose to accept the more fearful I am.

This chart, in my opinion, therefore shows the fear minus greed spread between the 30 year mortgage rate and the 3 month treasury bill. The higher the number, the more fear there is.

Here's the odd part. I've seen that chart before.



I know this sounds crazy, but ever since yesterday on the road, I've been seeing this shape. Shaving cream, pillows. Dammit! I know this. I know what this is! This means something. This is important. - Roy Neary, Close Encounters of the Third Kind, 1977

I must apologize. I'm fairly sure this joke is never going to get old to me. Sorry!!

One last thought. This is gallows humor. My girlfriend has been unemployed for about six weeks. Her former employer has not lifted a finger to help her (she can't even collect unemployment because the employer refuses to respond to the unemployment office).

See Also:
Employment Report Shows Stagnation?
"Fresh Inflation"
Motorola Equity Withdrawal (MEW)

Source Data:
FRB: Selected Interest Rates

Three Gorges Dam vs. Lawrence Yun

As China's mega dam rises, so do strains and fear
These days, China stands almost alone among nations in wielding the wealth and will to conjure up vast engineering efforts to alter the flow of rivers and lives of millions.

The housing market just refuses to stop. - Lawrence Yun, NAR Chief Economist

The dam region is granite-solid in parts but also spans brittle terrain. Scientists have long forecast greater instability as rising and falling dam waters punch at shorelines, block seepage, and squeeze weak spots.

We have been monitoring several markets where there could be significant stress due to the market correction. Chicago is not on that list. - Lawrence Yun, NAR Chief Economist

"The first sign will be cracks in the older homes, like ours," said a former resident of Qianjiangping, Wang Aihua, visiting his parents there. "Keep your eyes open for anything like that," he sternly told them.

The supply of homes is very tight for new and existing homes. We will continue to see healthy home-price appreciation. For non-home owners, that's bad news. But for home owners, that's building wealth. - Lawrence Yun, NAR Chief Economist

"Sometimes the ground rumbles and shakes, dogs bark, babies cry. It frightens us too," said Xiang's neighbor, Su Gongxiang, showing his front door that will no longer shut.

What we had in the past couple of years was an unprecedented frenzy of activity. That's what we're seeing: A decline from a frenzied, unsustainable rate. - Lawrence Yun, NAR Chief Economist

"We worry about staying but can't move," said Su Zhonghen, washing clothes in an outdoor stone sink that now skews to one side. "Only families with flooded homes get compensation."

Obviously, many renters have become homeowners as rates have fallen. - Lawrence Yun, NAR Chief Economist

NAR: Modest Recovery For Existing-Home Sales in 2008 as Credit Crunch Subsides
“Home buyers in it for the long haul nearly always come out ahead in building wealth. Given the leverage in purchasing a home, the average return on a 5 percent downpayment over 10 years is usually three to five times greater than stock market returns,” he said. “When people compare investment returns, they often overlook the power of leverage in the housing market.”

Mr. Yun, I think you might be forgetting the $400 trillion in derivatives and the 9,000+ hedge funds squeezing massive profits out of pennies. But hey, that's probably a bad comparison anyway. That would imply leverage is risky, but as we all know, home prices only go up! Woohoo!

Source Data:
Think Exist: Lawrence Yun quotes

Features and Risks of Treasury Inflation Protection Securities

Kansas City Fed: Features and Risks of Treasury Inflation Protection Securities
These assets have virtually only one risk: the risk that the real interest rate prevailing in the market will change. In contrast, all other financial assets currently available embody more than one risk. In particular, conventional Treasury bonds have both real interest rate risk and inflation risk. Thus, Treasury indexed bonds provide investors with a safer asset than has historically been available.

So let's talk about that primary risk. The risk here is that real returns rise and we'll be stuck with an inferior rate. Just how bad is it though if we're investing for the long-term? Let's say we have a 10-year TIPS yielding 2% over inflation and we'll hold it until maturity. Now let's say we fall asleep for 10 years and awake to see how we did.

Since we held until maturity, we got 2% over inflation. We knew that before we fell asleep. No big surprise there. So what are we hoping to see now that we've woken up? We want to see much higher real rates so that we can reinvest in even better yielding TIPS and go back to sleep for another 10 years! If rates are actually lower, we're going to be less happy, right?

So how does this real return risk work in the real world? If interest rates rise the 2% TIPS will become worth less to others. Who wants to be stuck earning 2% over inflation when you could be earning 3% over inflation? Oh well! Cry us a river. If you buy a TIP fund (or try to sell your 2% TIP in the secondary markets before it matures) you will feel that missed opportunity cost directly. You can lose money if you don't keep a long-term perspective. However, a TIP fund is simply a collection of TIPS. In the long-term, if you are comfortable owning TIPS, then you should also feel comfortable owning the fund. That being said, this real interest rate risk is a real risk. In theory, real interest rates could continue to climb throughout your life, and the fund could suffer each and every year as a result. At some point though, the real return would be so high you'd be sitting in a prosperity generating machine though, so the odds of it being infinitely sustainable seem rather remote (especially these days).

Generally, real interest rates are highest when the economy is doing the best and lowest when the economy isn't doing so well. I say generally because real interest rates were very high during the Great Depression (since the price of goods dropped considerably). The 1970s saw negative real rates as did the dotcom bubble's aftermath. I'm bearish on real rates, for what that's worth. I think the high real rates heading into the dotcom bubble will not soon be repeated.

Unfortunately, because the tax code does not distinguish nominal income from real income, the tax burden of an investor in indexed bonds increases when inflation increases. Consequently, in terms of after-tax yield, even indexed bonds are not entirely inflation risk free.

If the government wants our wealth badly enough, it will get it no matter what we do. If it takes a wheelbarrow of dollars to buy a loaf of bread someday, TIPS would go to zero just like every other paper promise. I do not scoff at those who would make such an assertion but I'm not betting on that outcome either.

Even though the tax code brings inflation risk back to indexed bonds, the risk is small compared with nominal bonds.

The reason TIPS would be feeling tax pain during severe inflation is because they would be paying so much interest. You could certainly have worse problems to deal with, namely earning little interest by being locked in a long-term non-inflation protected treasury at a low interest rate.

I-Bonds are even safer than TIPS in my opinion, since they are tax deferred up to 30 years and therefore reduce the tax risk as mentioned above.

There is at least one more risk not mentioned. Do you trust the CPI or don't you? Can you trust it in the future? I trust it more than many, but certainly not at 100%. Even if it was 100% accurate for us as a group, it couldn't be accurate for all of us individually. We don't all spend money exactly the same way.

Once again, this isn't investment advice. I'm just trying to protect myself against a fairly worst case outcome (but not the worst case, or I'd still be in gold and silver). I'm an inflation/deflation fence rider most of the time, since I think both forces are rather powerful. I continue to be amused that the consensus of my latest poll is riding the fence right along with me (12 recession disinflation, 12 stagflation). Go figure.

Flow of Funds Fun! v.2

The following three charts show the growth in various parts of our economy per capita and adjusted for inflation. They are plotted on a logarithmic scale so that constant growth shows as a straight line.

First up, the big picture.



1950-2007 (Per Capita, Inflation Adjusted)
Real estate asset growth: 2.61%
Replacement-cost value of structure growth: 2.33%
Disposable personal income growth: 1.85%



1950-1997 (Per Capita, Inflation Adjusted)
Real estate asset growth: 2.52%
Replacement-cost value of structure growth: 2.27%
Disposable personal income growth: 1.99%



1997-2007 (Per Capita, Inflation Adjusted)
Real estate asset growth: 5.81%
Replacement-cost value of structure growth: 4.41%
Disposable personal income growth: 1.56%



This shows the real (inflation adjusted) year over year annual growth in the value of residential real estate asset prices per capita. The shaded areas represent economic contractions. John M. Berry (see below), please note what tends to happen when the growth turns negative.

See Also:
Flow of Funds Fun!
Calculated Risk: Bloomberg's Berry: No Recession

Source Data:
FRB: Flow of Funds Accounts
U.S. Census Bureau: International Data Base
BLS: Consumer Price Index
National Bureau of Economic Research, Inc.

Flow of Funds Fun!

This chart shows the total residential real estate assets divided by the total residential real estate replacement costs. The shaded areas show economic contractions. If we truly are running out of land you would expect this trend to go up. Note the last time we apparently ran out of land was in the late 1980s, right before our last consumer recession. Japan also ran out of land then as well. This Time It Is Different™ though. You can never have too many condominiums!

Miami condo at ground zero in mortgage fraud
But the 643-unit condo known as the Club at Brickell is a leader in mortgage foreclosures and it appears also to stand at ground zero in a blizzard of fraud that may lie behind many of the failed loans threatening to bury the U.S. property market.



This chart shows the total residential real estate assets divided by the total disposable personal income. The shaded areas show economic contractions. Anyone see a problem here? It seems a bit high relative to the red trend line. How about more than one problem? The recent trend doesn't seem to be up any longer. Shall I go for three? Recessions tend to start when the trend heads down. Dare I try for a fourth? I shall! It has been so long since that trend headed down that many have forgotten what might happen. How about a fifth? Your choices are Vodka or Scotch! I'm thinking you might want both. Bottoms up!

Real Estate Confidence: Build It Up, But Don't Forget The Facts
No amount of shunning media stories or ignoring foreclosure stats can make up for the fact that houses in this country are just too expensive. You want to juice the market? Lower the price. The crazy record appreciation we saw at the beginning of this century was unwarranted and undeserved, and it came darn well close to tanking our entire credit system. That's a cold hard truth and Realtors should educate their clients about that.

It came darn well close to tanking our entire credit system? What stopped it? I'd really like to know.



Here's a chart from 1950 to 1997 showing the growth in various parts of our economy. It is not adjusted for inflation or population so therefore we would expect to see a lot of growth. It is plotted on a logarthmic scale so constant growth is shown to be a straight line.

Total residential real estate asset annual growth: 8.39%
Total residential real estate replacement cost annual growth: 8.03%
Total disposable income annual growth: 7.68%

There's probably not much to be alarmed about here. Overall disposable income did a fairly decent job keeping up with overall home prices (assuming you are CEO and your job wasn't outsourced to China that is).



Here's the chart from 1997 to 2007.

Total residential real estate asset annual growth: 9.37%
Total residential real estate replacement cost annual growth: 7.98%
Total disposable personal income annual growth: 5.13%

Hey, isn't that something. As both the disposable personal income and replacement costs began to decelerate, the price of real estate actually accelerated. How could this be? Who was telling us to commit money we didn't actually have to real estate?

Here's another thought. If you really want replacement costs and disposable personal income to decelerate, there's no better thing than a global housing bust and/or global recession. Let's not go there though, as that would make for a very nasty deflationary feedback loop. Disposable income drops, people can't afford homes or shopping mall experiences, unemployment rises, housing prices drop more, lather, rinse, and repeat.

Have no fear! Helicopters are standing by to drop fresh cash to those who need it. Unfortunately, any cash used to prop up your personal disposable income will simply make things more expensive. It doesn't actually solve the problem, but it sure will make the problems seem solved if you factor out stagflation! You see, Ben Bernanke can't actually print prosperity. All he can print is money. It can seem the same as long as we push the true cost onto the generation that follows us and we all pretend that everything is okay though. Woohoo! *extra sarcasm*

See Also:
Calculated Risk: Bloomberg's Berry: No Recession

Source Data:
FRB: Flow of Funds Accounts
National Bureau of Economic Research, Inc.