Comments people emailed me and my responses:

Bob Hart wrote:

http://www.wtrg.com/prices.htm

This graph supports your statement below:
Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades

Thanks!

“So, there is nothing the US can do to keep core inflation in check? Only the Saudis (and other oil producers) control US inflation?”

In this case, yes. If the Saudis keep hiking cpi goes up and an inflation begins via the various channels that connect energy with other prices. And in this case exacerbated by our pension funds.

right: previous high inflations have always been: energy, food, and shelter costs. I haven’t looked at shelter costs this time around.

Great piece. I’ve been thinking along the same lines over the last few weeks. I wish I had been a lot shorter the long end but think that trade still makes sense, especially given future deficits over the next 3-5 years. Having been born in the 1980s and not lived through oil embargos, stock market stagnation and hyper inflation, I am not exactly sure what the play is over the near-term and longer term. If you were to set up a portfolio that couldn’t be changed over the next 3 yrs / 5yrs / 10yrs what do you think the mix should be?

I like AVM’s current mortgage construction: buy FN 5′s versus tailored swap at LIBOR plus 25 basis points with a ‘free’ embedded put. Put it on and sit tight for Fed hikes. Worst case you get LIBOR plus 25.

Call your AVM salesman ASAP before the spread vanishes!!!

Do you buy TIPS / Broad based commodities indices (DJP) / Gold / Stocks / short end / long end?

‘Raw’ TIPS imply a low real rate. If the Fed decides to rais the real rate, you lose.

You could do a 10 year break even bit, especially in Japan, but I like the mortgage trade better.

Think that you could get killed owning bonds but input prices have already run so much its hard to buy commodities in a potentially declining demand environment. Do you buy stocks hoping they simply stay inline with inflation or do you just hold cash?

In the medium- and long-term the S&P will probably more than keep up with inflation, but help to get the right one and to get the right entry point.

Thanks for the help. I know you are busy but any insight would be much appreciated. thanks.

I agree entirely with the view that the 1970s was a question of energy prices, a supply-side phenomenon rather than anything else. The implications for policy are important; we might produce a problem where it does not exist if policy is predicated on the wrong interpretation of the problem.

Looks very much like the 1970′s to me.

Yes, the labor situation was different then – strong unions due to strong businesses with imperfect competition, umbrella pricing power and the like.

But it was my take then that inflation was due to energy prices, and not wage pressures. Inflation went up with oil leading throughout the 1970′s and the rate of inflation came down only when oil broke in the early 1980′s, due to a sufficiently large supply response. It was cost push all the way, and even the -2% growth of 1980 didn’t do the trick. Nor did 20%+ interest rates. Inflation came down only after Saudi Arabia, acting then as now as swing producer, watched its output fall to levels where it couldn’t cut production any more without capping wells, and was forced to hit bids in the crude spot market. Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades, and inflation followed oil down. And when demand for Saudi production recovered a few years ago they quickly re-assumed the role of swing producer and quietly began moving prices higher even as they denied and continue to deny they are acting as ‘price setter’ with inflation again following.

And both then and now everything is ultimately ‘made out of food and energy’ and hikes in those costs work through to everything else over time.

There are differences between then and now. A new contributor to inflation this time around are our own pension funds, who have been allocating funds to a passive commodity strategies as an ‘asset class.’ This both drives up costs and inflation directly, and adds to aggregate demand (also previously discussed at length).

Also different is that today we’ve outsourced a lot of the labor content of our gdp, so I suggest looking to import prices of high labor content goods and services as a proxy for real wages. And even prices from China, for example, have gone from falling to rising, indicating an inflation bias that corresponds to the wage increases of the 70′s.

Costs of production have been going up as indicated anecdotally by corporate data and by indicators such as the PPI and its components. These costs at first may have resulted in some margin compression, but recent earnings releases seem to confirm pricing power is back and costs are pushing up final prices, even as the US GDP growth slows.

US policies (discussed in previous posts) have contributed to a reduced desire for non residents to accumulate $US financial assets. This plays out via market forces with a $US weak enough to entice foreigners to buy US goods and services, as evidenced by double digit growth in US exports and a falling trade gap. This ‘external demand’ is providing the incremental demand that helps support US gdp, and corporate margins via rapidly rising export prices.

World demand is high enough today to support $100 crude, and push US cpi towards 5%, even with US GDP running near zero.
As long as this persists the cost push price pressures will continue.

Meanwhile, markets are pricing continued ff rate cuts as they assume the Fed will continue to put inflation on the back burner until the economy turns. While this is not a precise parallel with the 1970′s, the era’s were somewhat similar, with Chairman Miller ultimately considered too soft on inflation during economic weakness. He was replaced by Chairman Volcker who immediately hiked rates to attack the inflation issue, even as GDP went negative.

Initial Jobless Claims (Feb 16)

Down a bit but lost a day in California. Chart looks like it’s drifted to a bit higher levels.

Still not recession type numbers yet, however.

Continuing Claims (Feb 9)

Also looking like it’s moved up to higher levels, but still far from typical recession levels.

Philadelphia Fed. (Feb)

Looks serious!  Strange that employment was up 2.5, however, and, of course, prices on the rise.

Leading Indicators (Jan)

Still drifting lower, but no collapse.

Trichet May Not Cut Rates in 2008, Say Merrill, ABN

by Simon Kennedy
(SNIP)
(Bloomberg)Erik Nielsen, Goldman Sachs’s chief European economist, disagrees. He said the ECB’s primary mandate is to preserve price stability, so it has no room to follow the Federal Reserve and the Bank of England, even as economic growth weakens. The Fed slashed its main rate by 1.25 percentage points last month, and the Bank of England cut its benchmark by a quarter point Feb. 7 for the second time in three months.

‘Hurdle’
“Inflation and expectations for it are a hurdle for a cut,” Nielsen said. “Inflation is very stubborn” in Europe.

The annual pace of consumer-price increases in the euro region accelerated to a 14-year high of 3.2 percent in January, pushed above the ECB’s 2 percent limit for a fifth month by food and energy costs. Inflation in France, the euro-area’s second largest economy, accelerated in January to the fastest pace in at least 12 years, according to data released today.

US CPI is up nearly 4.5% year over year with no let up in sight, and core measures are above FOMC comfort zones and picking up steam as well.

This is one of the Fed’s pet inflation expectation indicators.

The commodity surge continues, and food/energy/import/export prices are finding their way into core inflation.

Fed funds futures still pricing in a near 100% chance of a 50 cut on March 18.

MBAVPRCH Index (Feb 15)

MBAVREFI Index (Feb 15)

These look very weak.

Banks are not included, so there’s a chance the banks could be taking market share from the mortgage bankers.

Consumer Price Index MoM (Jan)

CPI Ex Food & Energy MoM (Jan)

Consumer Price Index YoY (Jan)

CPI Ex Food & Energy YoY (Jan)

Today’s CPI report shows inflation is moving up sharply. If it was above Yellen the dove’s comfort zone last week it even further above it now. Same with Mishkin, who more than once said the FOMC had to be prepared to reverse course as needed.

Stocks are sensing they may be ‘on their own’ if the Fed is constrained by inflation.

Yes, the economy is weak, growth near 0 (see housing below), but demand is high enough to keep pushing food, crude, and import/export prices ever higher.

The Fed seeks an output gap/GDP growth consistent with inflation within their comfort zone.

Stronger growth will increase their inflation forecasts, while weaker growth is expected to bring inflation down.

Higher prices for food and crude are also presumed to bring out supply side responses, thereby bringing prices down.

But they also believe this has to happen before inflation expectations elevate, otherwise the higher prices get ‘monetized’ and a relative value story turns into an inflation story.

The data is now showing that is starting to happen, and for most FOMC time has probably run out. They may now feel they have used up all the past ‘credibility’ that has kept inflation expectations ‘well anchored’ trying to ‘forestall’ a financial collapse.

Housing Starts (Jan)

A glimmer of hope, but not much, but still winter numbers. Better picture will emerge by March.

Building Permits (Jan)

No sign of a turn here.

From Karim:

Core up 0.311%; with headline spurred by food and energy (each up 0.7%). Y/Y up to 2.5% from 2.4%

OER up another 0.3% and medical up 0.5%

Some items unlikely to repeat next month are lodging away from home, which was up 1.1%.

Also, apparel (which was up 0.4%) has now risen 5 straight months. This series usually chops around and like lodging away from home, has seasonal adjustment issues. Tobacco up 1.1% after 0.8% prior month. Expect all of these to reverse over next 1-2 months.

Maybe, maybe not. With import prices and local costs rising, cost-push-inflation can keep things moving up until all catches up with food/energy numbers.

Also, many wage agreements, including government, and other contracts have CPI escalators, which sustain demand for the ever higher prices.

Housing starts tick up 0.8% from downwardly revised December number; single family starts down another 3% to lowest since 1/91

Building permits down another 3% (typically leads starts)

Bottom line is Fed is likely to believe that the pattern of growth and inflation of the past two easing cycles will repeat itself (chart attached); that is inflation typically peaks about 2-3 years after the peak in growth. Fed Member Stern (voter) referred to this yesterday where he said he expected core to come down over the next several years but not anytime soon, and that recent rate cuts were ‘wholly appropriate’.

Agreed, they may believe that, but they also believe that if inflation expectations elevate, the higher prices get ‘monetized’ and don’t revert.

That’s why they are so focused on the inflation expectation indicators, which they also know are difficult to read and not considered completely reliable.

Should the Fed turn it’s attention to inflation, it will find itself way behind that curve.

The US cpi is about 100 bp higher than the eurozone cpi’s, including the UK where rates are north of 5%.

With US inflation where it is, the mainstream calculation for the appropriate ff rate is probably north of 7%.

The way the mainstream now sees it, the more the Fed cuts to get ahead of the ‘economy curve’ (whatever that is), the further it gets behind the inflation curve.

At this point if may not take much in the way of economic ‘improvement’ to redirect the Fed’s attention. A sign of a housing turn might be sufficient.

And with a general inflation underway, housing prices will go up as well, regardless of weakness, due to cost pressures, much like the late 70′s.

Highlights:

Russia exercising it’s pricing power as a swing producer as well.

Lukoil Cuts German Oil Exports by Pipeline on Pricing (Update1)

by Torrey Clark and Thom Rose

(Bloomberg) OAO Lukoil, Russia’s largest independent oil producer, may cut March shipments of crude oil to Germany by pipeline, continuing the halt ordered yesterday because of a pricing dispute.

Lukoil stopped February exports through the Druzhba pipeline and will consider cutting March sales while demanding higher prices from traders in Germany, spokesman Dmitry Dolgov said by phone today. The Moscow-based oil producer has reserved space in the pipeline for next month, he said.

“Why should we sell oil cheap?” Dolgov said. “We have found alternatives.”

German refineries tapped fuel from alternative sources last year to supply their customers when Druzhba shipments fell as Lukoil and Sunimex Handels-GmbH, the dominant oil trader, clashed over prices in July and August. PCK Raffinerie GmbH in Schwedt said the disputes haven’t affected output.

“We haven’t had any problems or production cuts,” PCK Schwedt spokesman Karl-Heinz Schwelnus said today by telephone.

Lukoil will renew attempts to sell oil directly to the refineries, Dolgov said. The company isn’t breaking any contracts by cutting shipments and the refineries are unlikely to run short of crude, he said.

“German drivers have nothing to worry about,” Dolgov said.

NAHB Housing Market Index (Feb)

Still a possible bottom forming.

Coming out later today..

ABC Consumer Confidence (Feb 17)

[comments]

(an email)

> On Feb 19, 2008 10:03 AM, Mike wrote:

> Warren, note spec comments and dollar issues, a big hurdle to overcome
> if they go the other way …
> Mike

Hi Mike,

Agreed the dollar may have bottomed. Seems to have reached a level where exports are now growing at about 13% which maybe is the right number to accommodate the pressure from the non resident sector to slow it’s accumulation of $US financial assets.
However I continue to conclude the price of crude is being set by the Saudi’s/Russians acting as swing producer, and that there is sufficient demand to keep them in the driver’s seat. Quantity pumped keeps creeping up at current prices, with Saudis last reporting 9.2 million bpd output.

Crude at 98.70 now. Note crude goes up on news a refinery is down, when refineries are the only buyers of crude, so in fact it’s going up for other reasons (price setting by the swing producer?). Also, WTI is now ahead of Brent, indicating whatever was causing the sag in WTI vs Brent is over. WTI would ordinarily trade higher than Brent due to shipping charges.

Warren

Interesting they would take a shot like that at the Fed. Probably concerned about Euro strength and the US gaining export share.

Bank of France Says Fed Overreacted to Market Decline

By Francois de Beaupuy

(Bloomberg) The Bank of France said the U.S. Federal Reserve may have cut interest rates too much and too quickly in response to financial-market declines.

An unsigned article in the Paris-based bank’s monthly bulletin, published today, said new financial products have amplified asset price swings.

That may lead to “stronger monetary reactions than what would otherwise be necessary, as shown by the recent decision of the Federal Reserve,” the article said.

The unusual criticism by one central bank of another may reflect the European Central Bank’s reluctance to follow its U.S. and U.K. counterparts in cutting rates to cushion against an economic slowdown. The ECB left its benchmark rate at 4 percent this month even as growth prospects deteriorate.

“The Bank of France is simply going along the ECB line, trying to manage expectations away from any response similar to the Fed,” said Gareth Claase, an economist at Royal Bank of Scotland Plc in London. “The Fed moved quickly and far. The ECB is likely to move slowly and little.”

The Fed has lowered its benchmark rate by 2.25 percentage points since September to 3 percent — including a three-quarter point emergency cut on Jan 22 — and traders expect another reduction next month.

‘Unusually High’
German Finance Minister Peer Steinbrueck said Feb. 12 he didn’t see ECB Bank President Jean-Claude Trichet shifting to a neutral stance, which might be a prelude to cutting rates. At a press conference last week, Trichet said uncertainty about growth prospects is “unusually high,” prompting traders to raise bets on a rate cut.

“Pressure on the ECB increased after the massive Fed rate cuts,” said Michael Schubert, an economist at Commerzbank AG in Frankfurt. “The ECB has said that it won’t act anytime soon. It doesn’t want to be driven by the Fed.”

German investor confidence unexpectedly increased this month, a sign the European economy can weather the U.S. slowdown.

“It’s unusual for central banks to criticize the actions of others,” said Dominic Bryant, an economist at BNP Paribas in London. “The U.S. is in recession, so it’s somewhat difficult to say the Fed overreacted.”

Might be a revealing day coming up.

I’m watching for markets to begin to link higher oil prices to the potential for higher interest rates, rather than the reverse as has been the case since August.

With oil up to the mid 97 range this am, the question is whether short term interest rates move higher due to possible Fed concerns about inflation, even with weak growth and continuing financial sector issues. Even Yellen recently voiced concerns about energy prices now feeding into core inflation measures which are now above her ‘comfort zone.’ And Friday Mishkin said more than once in a short speech that the Fed had to be prepared to reverse course if inflation expectations elevate.

Yes, credit spreads are a lot wider, but when, for example, I ask the desk if any of the wider AAA’s are ultimately money good, I get a lot of uncertainty. So it seems to me in many cases markets are functioning to price risk at perceived potential default levels? So some of the current spreads may be wider than they ‘should be’ but maybe not all that much?

Yes, the financial sector has been damaged (and damnaged).

Yes, housing is weak without the bid for subprime housing of 18 months ago.

And yes, the consumer has slowed down some.

However, exports are booming like a third world country- growing around 13% per year, also do to financial market shifts, this time away from $US financial assets.

This is offsetting weakening domestic demand and keeping gdp positive, at least so far.

Meanwhile, it looks like a full blow 1970′s inflation in the making if food, fuel, and import/export prices keep doing what they are doing.

And with Saudi production continuing to creep up at current pricing, seems demand is more than strong enough for them to keep hiking prices.

And suddenly Yellen and Mishkin, both doves, substantially elevate their anti inflation rhetoric, as core levels have gone just beyond even their comfort zones.

From today’s speech:

A central bank must always be concerned with inflation as well as growth. As I have emphasized in an earlier speech about inflation dynamics, the behavior of inflation is significantly influenced by the public’s expectations about where inflation is likely to head in the long run (Mishkin, 2007a). Therefore, preemptive actions of the sort I have described here would be counterproductive if these actions caused an increase in inflation expectations and in the underlying rate of inflation; in other words, the flexibility to act preemptively against a financial disruption presumes that inflation expectations are firmly anchored and unlikely to rise during a period of temporary monetary easing.

There have been recent signs of inflation expectations rising, including today’s jump in the one year Michigan expectation to 3.7%.

Indeed, as I have argued elsewhere, a commitment to a strong nominal anchor is crucial for both aspects of the dual mandate, that is, for achieving maximum employment as well as for keeping inflation low and stable (Mishkin, 2007b). Policymakers therefore need to closely monitor information about underlying inflation and longer-run inflation expectations, and the central bank must be ready to hold steady or even raise the policy rate if the evidence clearly indicates a significant rise in inflation expectations.

Says here he will vote to hike if expectations elevate.

Empire Manufacturing (Feb)

Down, but it has been lower, not yet to previous recession levels.

Industrial Production (Jan)

Modestly positive, and not at recession levels.

Capacity Utilization (Jan)

Holding up reasonably well.

U. of Michigan Confidence (Feb P)

The CNBC effect keeping expectations down.

One year inflation expectations jumped to 3.7% putting the Fed on high alert.

Survey shows people are watching TV and reading the newspapers.

For the third consecutive month, more households reported that their financial situation had worsened rather than improved over the past year.

But due to inflation, not falling nominal income:

Moreover, due to a higher expected inflation rate and smaller expected wage gains, 46% of all households anticipated declines in their inflation adjusted incomes during the year ahead, the worst reading since the 1990 recession.
Overall, consumers expected a year-ahead inflation rate of 3.7% in early February, up from 3.4% in the prior three months.

The Fed uses this as one of their inflation expectation indicators. It has gone from too high to even higher.

In contrast, long term inflation expectations, a proxy for core inflation, was unchanged and well anchored at 3.0% in February.

Yes, but still too high.

Eighty-six percent of all consumers thought that the national economy was in decline, the highest level recorded since 1982. Year-ahead prospects for the national economy were just as bleak as 72% expected bad times, a level comparable to the worst levels in the recessions of the early 1990′s and 1980′s. The anticipated downturn is expected to result in more joblessness in the year ahead, a prime concern of consumers. A rising unemployment rate was expected by 52% of all consumers in early February, up from 33% a year ago, and comparable to the peak levels recorded in the months surrounding prior recessions.

The rest is more of the same and shows influence of the media.

Personal Finances—Current went from 98 to 96

Not bad.

Personal Finances—Expected 116 to 108

As above.

The survey clearly shows expectations have deteriorated for both the economy and inflation.

Import Prices

Export Prices

(an interoffice email)

Looks familiar – the CB forecasting inflation falling from higher and higher levels as it move up rather than down as originally forecast.

———- Forwarded message ———-
From: Milo
Date: 2008/2/14
Subject: This Picture says it all, I recon – 86% OIS odds of a hike in March
To: Warren Mosler, Karim

The RBA has come to grips with Australia’s stark inflation reality. Inflation forecasts have been revised up significantly (see Figure 1), the RBA will deliver

more rate hikes and domestic demand will eventually slow. At the moment, forecasters are grappling with how high the terminal cash rate will be. Is it

7.5%, 8.0% or higher?

“However, the downside risks to growth have intensified since the last meeting, and markets are pricing in another rate cut..”

Zimbabwe’s Inflation Rises to Record 66,212%

by Brian Latham

(Bloomberg) Zimbabwe’s annual inflation more than doubled to 66,212 percent in December, the Central Statistical Office said in a document released to local banks.

The December figure “was an increase of 39,741 percentage points on the November rate of 26,470 percent,” the office said in the document released in the capital, Harare, this week.

Food and non-alcoholic beverages rose 79,412 percent in December, while non-food inflation was 58,492 percent, the office said.
Zimbabwe has the world’s highest rate of inflation and the world’s fastest-shrinking peace-time economy, according to the World Bank. The International Monetary Fund estimated inflation reached 150,000 percent in January, the Zimbabwe Independent reported, citing a document that hasn’t been officially released by the lender.

Agreed that government can buy stocks to keep them from falling, as HK did.

But the 1930s was a gold standard deflationary collapse.

The Fed was constrained from net buying anything due to the risk of losing gold reserves.

The risks are very different now with non-convertible currency/floating fx:

Depression risk might force U.S. to buy assets

by John Parry

“The Fed probably can’t fix it all on its own now,” Connolly said. “There is a chance the Fed gets forced into unconventional cooperation with government,” which could involve buying a range of assets to reflate their value.

Operationally this can be readily done. But what assets would the Fed want to reflate? Equities represent a return on investment, which is what it is. Yes, it might make sense to have a bid, like HK did, for ‘market-making stabilization’ purposes, but not to hold longer term, as that would be public ownership of the means of production, etc.

That would be reminiscent of some steps the U.S. government took in the 1930s when the economy was mired in deflation and high unemployment.

One turning point came when agricultural prices were restored to their pre-slump levels, Connolly said. Such measures were among the New Deal programs that President Franklin D. Roosevelt launched to bolster the economy.

Note that we don’t have a problem with low agricultural prices today!

Nor with low energy prices or plunging nominal wages.

Only housing prices have been falling due to excess inventory that I calculate will be cleared in a few months. The risk is that housing prices rise after that.

Either way, investors face bleak prospects now without some kind of further government intervention, he said.

Investors, yes. Consumers, not so bleak. Jobs and income are holding up, and most forecasts are only minor rises in unemployment. And with booming exports and the fiscal package in place, GDP has been revised up.

Those steps might offer clues to investors in stocks and commodities, which Connolly expects the government might be ultimately force to step in and buy to stabilize markets.

Yes, as above. Maybe some market stabilization in the financial sector. I don’t see anything in the real sector that needs more government buying right now. Seems CPI is high enough as is for more mainstream economists.

He expects that a depression may be averted, but only by the state and the Fed reinflating the price of such assets.

If we do get a recession, it will be due to falling demand from something like a tax hike to balance the budget.

Beleaguered housing, non-government fixed-income securities and even the now overvalued Treasury market have little hope of generating substantial returns for investors over the next few years, he said.

Earned income is sufficient to drive effective demand, even without investor income.

“If we don’t avoid depression, the only thing worth holding is cash,” he added.

As we watch it buy less and less CPI? Looks more like we are turning the currency into wallpaper, at least so far.

As long as resources producers spend their incomes on imports of real goods an services (and don’t ‘save’ it), world demand is likely to be sustained at whatever prices they wish to charge.

Twin themes seem to be continuing: weaker demand with higher prices. But no recession, yet.

Year over year export growth is looking strong and today’s Dec number revises Q4 GDP estimates to up 1% (vs initial government report of up 0.6%).

Also note that Q4 lost 1.25% as inventories built in Q3 were drawn down. Smooth the inventory numbers for Q3/Q4 and that implies Q3 would have been up 3.65% and Q4 up 2.25%.

This also supports the upwardly revised December payroll number.

The likelihood of strong January exports is one factor that leads me to suspect the January employment number will be revised up as well.

And if exports continue to grow at current rates though Q1 it will also be higher than expected, with exports continuing to pick up the slack from housing.

YoY Export Growth