Inflation is back on the agenda

Good morning. Oil major Chevron plans to cut 20 per cent of its 46,000-person workforce as part of an efficiency drive. Whether Chevron’s leadership took this decision because they believe President Donald Trump is going to cut US energy prices by half, as he promised on the campaign trail, is unclear. Send me your oil price predictions: robert.armstrong@ft.com. 

Inflation

January’s CPI inflation reading was bad, and particularly bad measured the way Unhedged prefers, annualising the month-to-month changes:

Note that food and energy are excluded in that chart, so runaway egg prices were not a contributor. Instead, what we got was a notably broad-based increase in prices, for goods and services alike. Shelter inflation, with its very high weighting in the index, is not as bad as it was six months ago, but it’s still a big reason why the index is above the Federal Reserve’s 2 per cent target. And the problem is not just the lagging measure of imputed (“owner’s equivalent”) rent. Plain old rent is trending higher the last two months:

There was a particularly high jump in volatile price series such as used cars, airline tickets and car insurance. Used cars, for example, have just a 2 per cent weighting in the overall index, but their increases recently are big enough to make a difference:

It is tempting to look past steep rises in volatile prices, but the temptation should probably be avoided. As Jason Furman of Harvard summed up in a tweet yesterday:

Flukes . . . elevated January inflation. But in the nearly thirty years from 1992 to 2019 there were also all sorts of flukes. And this is at the 99th percentile of 3-month core inflation over that period. That is the issue: the good months are normal but the bad months are horrible.

The “January effect” may be at work here, too: the index’s seasonal adjustments struggle to deal with the wave of annual price increases that occur in the first month of the year. Bob Michele of JPMorgan Asset Management points out that January inflation has surprised to the upside in 14 of the past 15 years. But the Fed (and the rest of us) can’t write off this month’s numbers on these grounds. All we can do now is wait and see if the next few months are better.

In all, yesterday’s numbers provide support for the Fed keeping rates where they are for now, and suggest that there might be no cuts at all this year. Given this, the market reaction to the report was slightly puzzling. Stocks fell only slightly on the day. And the yield curve steepened slightly, with 10 and 30-year Treasuries moving more than the two-year. One might have expected a higher-for-longer Fed meant higher short-term rates and lower long-term growth prospects, and as such a flatter curve.

The muted reaction from stocks makes more sense when you remember that we have had quite high rates for more than two years now, and corporate earnings growth has kept on humming. It appears that Fed policy only transmits to quite specific parts of the modern corporate economy, and indeed stocks in those parts — homebuilders and construction-related businesses — did take a hit yesterday. 

On the yield curve, Jim Caron of Morgan Stanley offered me a tidy explanation of the steepening: while after yesterday’s report the Fed looks more likely to keep rates at their current high level for longer, they remain unlikely to increase rates. “There is little risk . . . the Fed [will] hike rates while at the same time it seems that inflation risks are rising. This is causing a natural adjustment in risk premia to rise in longer-term bonds,” he said.

This, it seems to me, is a way of saying that the market is pricing in a higher long-term neutral rate of interest. The market is not just adjusting to higher for longer; it’s adjusting to the possibility of higher forever.

Bonds, stocks and constitutional crisis

Over at Marginal Revolution, Tyler Cowen raises a challenging and daunting question. How do markets respond if Trump, as some commentators worry he might, ignores court orders blocking his policies, sparking a constitutional crisis?

Which are the securities prices that would indicate an actual constitutional problem? Particular equities? Interest rates? The value of the dollar? Measures of volatility? Something else?

I am allergic to the view that ‘fascism could come and market prices would not even budge’ . . . I think fascism, or a constitutional collapse, would be a terrible outcome in a variety of very practical ways . . . So people, on this question, which exactly are the measurable, market price indicators?

Before I take a shot at this, three clarifications. First, in the case of a constitutional crisis, what markets do will of course be a minor concern. Next, I’m not taking any position on the question of how likely such a crisis is, except to note that the question is in the air. Finally, while I share Cowen’s view that constitutional collapse would be terrible economically (that’s what I take him to mean by “practical” above), I do not share his confidence that this implies the market would respond to such a collapse in a well-calibrated, easy-to-read way. My sense is that markets are bad at discounting political risk, and that the likely response would be pretty erratic.

But that doesn’t mean there would be no response. Start with bond yields, breaking them into inflation expectations and real rates. If the president decides to override one independent institution (the courts), perhaps it is natural to think he will then override another (the central bank). If he did, that would drive inflation expectations up. But I think this president really cares about popularity, and remembers what high inflation did to his predecessor. If inflation keeps running hot, I think Trump will stay out of the Fed’s way, even if he begins to trample the court.

That leaves real rates. And it seems to me that in a system where the president is no longer bound by the constitution, real rates and in particular long-term real rates have to rise, because investors will demand a higher term premium to own US debt. One might be confident that a particular imperial president will run sane monetary (or fiscal) policy, but who knows what the next one will do. In a Trumpian constitutional crisis, I would expect long rates to rise more than short rates.

On to stocks. Let’s disaggregate again, this time into earnings expectations and valuation multiples, and further break down earnings expectations into short and long term.

Whether short-term earnings expectations fell in a constitutional crisis would depend largely on how consumers responded. Do some of them respond to the crisis by putting off non-essential purchases, especially big items such as new cars or home renovation projects? If so, there would be a pretty sharp earnings shock. But perhaps another group of consumers would feel nothing but relief when the meddling courts are swept aside. It could be a wash; I really have no idea. What I am confident about is that a breakdown in the constitutional order would reduce capital investment, and therefore long-term earnings growth. What global company would not moderate their long-term investments in a lawless America?

The question of what happens to valuation multiples is much harder. Reflexively, one might think that a constitutional collapse would reduce the large premium currently paid for US risk assets. But I’m not sure. Remember, by way of analogy, the way the dollar tends to strengthen when the US economy is in bad shape. The idea is that when America is in trouble, the world is in trouble, and that a troubled world rushes for the safest currency, the dollar. Similarly, if the world is suddenly in the shadow of an imperial America, might the shares of a large US company be the safest place to put your money? 

I’m not very confident in any of these views, and clearly there is much more to say. I would be keen to hear from readers.

One good read

Cold football.