Inflation, asset bubbles, and interest rates

The lone dissenter at the last two Fed meetings, Kansas City Federal Reserve President Thomas Hoenig, talks to Fox Business news about, among other things, the perils of short-term interest rates that are left "too low for too long".

Hoenig compares the last decade to the early 1970s noting, "we have had an extended period of negative real rates and we know what followed in the 70s. Now that's not necessarily what's going to follow now, but it is a concern."

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That mysterious CPI shelter component

Well, it looks like whatever it was that was going on last month within the shelter category of the Labor Department's consumer price data is now back to normal in this month's report. As shown below, after considering the respective component weightings, the total seems to make sense in February (in green) versus the oddity that was January (in red).

Recall that, about a month ago in A math problem at the Labor Department? this question of addition was raised after the -0.5 percent decline in shelter costs caused the widely publicized first negative reading on month-to-month core inflation in many, many years.
What looks to be an obvious error was attributed to seasonal adjustment. That is, after the weightings (in blue) are adjusted for seasonal factors they somehow allow the lodging away from home component to greatly impact the shelter total.

All else being equal, you'd have to increase the lodging away from home weighting by a factor of ten to get the overall shelter total as reported in January. Do that many more people travel in January than during other months of the year?

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Zero inflation in February

The Labor Department reported zero inflation for the month of February as rising prices for medical care and education were offset by sharply lower costs for energy and apparel. This comes after a 0.2 percent increase in January and marks the eleventh straight month that the price index did not drop after a series of steep declines beginning in late-2008.
On a year-over-year basis, the overall consumer price index was up 2.2 percent following an annual gain of 2.7 percent the month before, however, we may not have seen the last of rising annual inflation as recently higher gasoline prices are not reflected in the most recent data.

By category, it was a familiar story as health care and education costs continued their relentless advance while prices for many other goods again fell. The closely watched shelter component (within the housing category) was flat in February after a decline of 0.5 percent last month and is now down 0.4 percent on a year-over-year basis.
Energy prices were down 0.5 percent in February after an increase of 2.8 percent the month prior and are now 14.4 percent higher than a year ago. Last month, gasoline prices fell 1.4 percent but they are still almost 37 percent higher than last year at this time.

Recall that gasoline prices did not move much above the $2 a gallon mark last year until May, so there will be a few more months of big energy price increases in the period ahead.

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Complaining about inflation in China

While it's sometimes hard to believe any of the economic data coming from the Chinese government, the recent reports on consumer prices might be a little more suspect than other data given that complaints about inflation are rising sharply.

The Telegraph reports on the unease that the 2009 credit creation binge and rapid money supply growth are producing here in 2010 as consumers notice prices rising around them.

A record number of Chinese have complained that inflation is at an "unacceptable" level, as the Communist party warned that its very future depends on tackling rising prices.

In its latest quarterly survey, the People's Bank of China (PBOC), the country's central bank, said that 51pc of respondents were unhappy about inflation, the highest proportion since the survey began in 1999.

In February, China's consumer prices rose by 2.7pc year-on-year, up from a 1.5pc rise in January. The government has set a 3pc target for inflation this year, but some analysts have said the true inflation rate is already far higher, after an enormous increase in money supply last year.

In February, Chinese broad money rose by 25.5pc, well ahead of the government's 17pc target for the year.

In developing economies like China, food prices have a much bigger weight in the inflation statistics than here in the West and, apparently, that's becoming a problem as was seen back in 2007-2008. What's surprising to hear today is that complaints are higher than they were back then. Recall that there were price controls and hoarding in a number of countries for such staples as rice and, now, price controls for pork in China are set to begin anew.

A year or so removed from the worst economic crisis since the Great Depression, it looks like China is going to blaze the trail into the uncharted territory that will likely dominate much of this decade - rising inflation due to money creation on a scale that the world has never seen.

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Rising inflation and house prices in China

China Daily reports that consumer prices rose to a 16-month high in February, up 2.7 percent from a year ago, while producer prices are now rising at a 5.4 percent annual rate. This follows reports yesterday that, despite recent efforts to cool their housing market, property values saw year-over-year gains of 10.7 percent last month.
Food prices rose more than six percent from year ago levels and, while some economists say inflation will cool in the months ahead due to more favorable annual comparison, it should be clear that some of the recent $1+ trillion in government sponsored credit creation is now starting to show up in the prices of things other than housing and copper.

It doesn't look as though this is helping the housing market cool off:

Facing ever-rising housing prices in China, only 18 percent of mothers told a recent survey they were willing to let their daughters marry men who only rent their homes.

Apparently, in a country where the male-to-female ratio is already higher than normal due to the "one child policy", men are at a distinct disadvantage with their potential mother-in-law if they are not already, or soon-to-be, homeowners.

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Dr. Doom and Deputy Doom at CNBC.com

CNBC has two stories out this morning that should scare the bejeebers out of investors, but, the ongoing rally seems indefatigable as of late. Dr. Doom notes in this report that the odds of a double-dip recession were 20 percent before the recent spate of negative economic data.

Poor economic data in the US coupled with Europe's debt crisis are contributing to an increase of the risk of the US economy going through a double-dip recession, Nouriel Roubini, who predicted the 2007 financial crisis, wrote in a research paper.
...
The Roubini Global Economics benchmark scenario puts the risk of a double dip at 20 percent, while a slow, protracted, U-shaped recovery is given the highest probability of 60 percent.

But since the end of February new macroeconomic data from the US have come out and "they have been almost uniformly poor, if not outright awful," Roubini wrote.

Consumer confidence has "tanked", new home sales are "collapsing," existing home sales are also falling sharply, as is construction activity, while initial jobless claims remain "stubbornly high" above the 400,000 mark, he said.

Roubini was unimpressed by the 5.9 percent growth rate for the economy in the fourth quarter as it was largely an inventory rebuilding surge and it came at a time when the maximum impact of the government stimulus was being felt.

A Roubini "protege" (now there's a word that you don't hear too much anymore...) apparently known as "Deputy Doom" also showed up on CNBC.com this morning in this story about another topic that you don't hear too much about anymore - inflation.

'It's Going to Be Inflation Everywhere:' Deputy Doom
The global economy is entering a next "supercycle" phase that will generate inflation necessary for recovery, a strategist and protege of noted economist Nouriel Roubini told CNBC.

Arun Motianey, director of fixed income strategy at Roubini's RBG Capital, said the supercycles feature periods of commodity booms followed by busts, and the US economy is on the verge of an inflationary period that will generate a sharp rise in prices.

"We're heading into a world of inflation because we are highly indebted and we are indebted here in the US economy in the household sector and in the financial sector," said Motianey, author of the book "SuperCycles."
...
"It's going to be inflation everywhere and it's going to happen really through the weakness of the US dollar," he said. "Then inflation in those other parts of the world that are expecting appreciating currencies, they're going to inflate as well because that's the way you ultimately correct this."

You also don't hear too much about "supercycles" these days...

The idea that we were in the middle of a "commodities supercycle" a few years back and that it has been on pause - not over - will likely gain traction as we move further and further away from the cataclysmic events of 2008-2009.

Of course, economists seem to be doing their part to help in that regard and a subject that you do hear a lot of talk about these days is their sudden "embrace" of higher inflation (for the sake of recovery, that is), as seen in this piece at voxeu - A 4% inflation target?

At some point in the years ahead, economists will probably wish inflation was only 4 percent.

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A shocking turnaround in prices

This chart hasn't been updated in over a year and, with recent changes in both the Consumer Price Index and the Case-Shiller Home Price Index, the results are stunning.
Somehow, the bust of 2007-2009 seems to have been all so unnecessary, that is, if a more realistic measure of "inflation" had been used back in the middle of the last decade.

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A sudden interest in TMTGM by the BLS

Well, someone at the Bureau of Labor Statistics has been poking around here this afternoon and they spent a fair amount of time here. Hey! That's my taxpayer money, isn't it?
I've not heard from anybody on this subject yet but I did go through some calculations with some of the other categories in the most recent inflation data as a sanity check and, as far as I can tell, they've got an error in today's report as noted here earlier today.

It still seems to me that, despite what you may have read in the mainstream media and elsewhere today, monthly core inflation did not decline for the first time since 1982.

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Consumer prices rise modestly

[Major news outlets are reporting that core inflation has fallen for the first time since 1982, however, there appears to be a problem with the re-weighting of categories within the consumer price index - more on that later.]

The Labor Department reported that consumer prices rose 0.2 percent in January, paced by a surge of 4.9 percent in the cost of energy commodities, and, as the worst of the year-over-year energy price comparisons continue, annual inflation now sits at 2.6 percent.
Core inflation - excluding food and energy - was reported to have declined by 0.1 percent in January, the first monthly decline since 1982, and this was due in large part to a decline of 0.5 percent in the shelter component that contributes about 40 percent to the total.

By category, the report showed the same well established trend of recent months - steadily rising prices for medical care and education with huge year-over-year increases for the energy components within both the housing and transportation categories.
Gasoline prices surged 4.4 percent in January after a gain of 2.3 percent in December and fuel oil costs rose 6.9 percent after an increase of 0.9 percent the month prior.

In the case of housing, energy price gains such as home heating costs were offset by falling shelter costs that reportedly tumbled 0.5 percent in January leading to the overall monthly decline for the housing category as a whole.

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A review of 2009 predictions

It's that time of the year again - time to look back at the first of the year to see how yours truly did with his Predictions for 2009 and see if there was any improvement over the previous year, a feat that shouldn't be too hard to accomplish given the year that 2008 was.

Here's a recap of the last three years of annual prediction reviews:

• A review of 2006 predictions
• A review of 2007 predictions
• A review of 2008 predictions

Some of these are pretty interesting to look back at now, a few years later.

For example, a high of $650 an ounce for gold in 2006 and ending the year just below that mark would have sounded like bold calls at the time since the yellow metal had just broken through the $500 an ounce mark for the first time in 20 years. As it turned out, the high was about $75 short of the mark but the year-end price was spot on. But, today, those calls seem so ... 2006.

The self-grading system that has been in place here for the last few years (not to be confused with our self-regulating financial markets) has produced the following results:

• 2006: 6-As, 2-Bs, 1-C, 1-N/A
• 2007: 7-As, 2-Bs, 1-F
• 2008: 4-As, 3-Bs, 2-C, 1-D

I think I took it a little easy on myself last year, for obvious reasons, but I'm looking to improve upon those results now.

Let's see how things turned out for the 2009 predictions...

As always, let's begin with housing.

1. Another Bad Year for Housing

Once again, more pain in housing seems inevitable with liar loans and option ARM products reaching their critical years. If it already hasn't, that second home/investment property that seemed like such a good idea back in 2004 will turn into a nightmare in 2009.

As was the case last year, only real estate sales types will be predicting a rebound for home prices in 2009 though home sales will probably make a lasting bottom. Late-2009 and 2010 will be the time to start looking to buy property again, but there will be no need to hurry - contrary to what real estate sales types tell you, prices are not headed back up anytime soon. They may not go too much lower in 2010, but, except for places like Washington D.C. where the bailout business is booming, prices will be mostly flat through 2011 or 2012.

Next year, housing prices will fall another 10 percent nationally, based on the year-over-year change to the 20-city S&P Case Shiller Home Price Index for October 2009 (this report gets released at the end of December and showed an 18 percent decline last week.) It seems that home price declines have to ease up. For example, based on their current trajectory, by the end of next year the median home price in Los Angeles would be below $200,000, down from a high of $550,000 in 2007.

Grade: A

Last week's S&P Case Shiller Home 20-City Home Price Index showed a year-over-year decline of 7.3 percent, not far from the nice round number of minus 10 percent that was predicted. Also, while new home sales remain in a funk, the much larger existing home sales clearly made a bottom early in 2009 and, with a steady supply of low-priced foreclosed properties continuing to come on the market and housing incentive money gushing from Washington, that bottom should last.

For these reasons, an A is awarded, making this the latest in a series of very good predictions for housing, highlighted by 2006's The housing bubble will not pop and 2007's The housing bubble will pop.

Yes, this year is the year to start looking to buy property, but probably not until the second half of the year since the low interest rate/homebuyer tax credit programs seem to have pushed things back a bit. My wife and I plan to buy property in late-2010.

2. The Dollar Will Go Down

The trade weighted U.S. dollar rose in 2008, but that was an anomaly. There are many bad currencies in the world (most of them are bad, actually, the pound now probably the worst) but the greenback will have a hard time looking good on a relative basis after big negative GDP numbers are reported along with even bigger job losses.

The source of most of the world's financial market troubles over the last year or so will finally be appreciated by those who've been buying U.S. Treasuries and, despite the best efforts of the big players at the Comex, many of these people will buy gold instead.

By year-end, the U.S. Dollar Index will be at 70, after dipping into the 60s briefly, and economists will again marvel at how the trade deficit is shrinking due to higher U.S. exports, helping the U.S. economy to recover.

Grade: C+

The big negative GDP numbers and the big job losses for the U.S. came in the first half of the year, but economies around the world saw even sharper declines. Nonetheless, the dollar did go down in 2009, the U.S. Dollar Index rising from 82 to 89 early-on and then tumbling all the way to 74 before rebounding to end the year at 78.

The overall direction was right, but the magnitude was off by enough that this will be considered a slightly above average forecast.

There certainly weren't a lack of buyers for Treasuries last year in one of the more interesting developments that the folks in Washington are probably figuring will extend indefinitely into the future. They're probably wrong about that.

3. Broad Equity Markets will Rise

The Dow and the S&P 500 Index will gain 10 percent and most investors will be happy about this, not realizing that it would have to repeat this performance for the next four or five years to make up for the losses seen in 2008. It won't.

Foreign stocks will do much better than U.S. stocks - up about 20 percent on average by year end - and stocks in China will rise 30 percent. Here too, most investors will fail to appreciate the cruel nature of large declines and advances expressed in percentage terms - this will leave Chinese stocks 55 percent below where they began 2008 (i.e., before last year's 65 percent decline).

Gold and silver mining stocks will outperform all other equities in 2009 (this process is already well underway) and many retail investors will add gold stocks to their portfolio for the first time only to sell in a panic during the first correction.

Grade: B

The broad U.S. stock indexes rose about double the predicted 10 percent and emerging market stocks were up even more, some of them shockingly so. It's a good thing none of them are bubbles, because we've had enough bubbles in the last decade that we don't want to go into the next decade with large bubbles already forming.

We'll see how that works out...

Once again, the direction was good, but the magnitude was off and mining stocks did quite well last year - up around 40 percent - but emerging market stocks did even better.

4. Short-Term Interest Rates Will Stay at Zero

Short-term interest rates in the U.S. will end the year where they began - at zero.

Instead of the Fed funds rate, the new metric that will be used to gauge what the Federal Reserve is doing will be the Fed's balance sheet. Now at $2.2 trillion, this will grow to over $4 trillion by year-end, by which time the weekly H.4.1 report will become a major news event.

Ben Bernanke aged five years over the last twelve months - over the next twelve months he will only age two years.

Grade: B+

Predicting the Fed funds rate has become way too easy, at least for me. Looking back over the last few years, this has been one of the most accurate groups of predictions and that's not likely to change in the period ahead. In fact, I can tell you right now that a year from now, short-term rates will still be zero.

As for the Fed's balance sheet, despite many calls for a much higher total, it ended the year about where it began - at $2.2 trillion and that's why the grade is a 'B' instead of an 'A'. Maybe next year, I'll stick with just the Fed funds rate call to increase my chances of getting an 'A'.

What's interesting when looking back over the last year is that, while the Fed's balance sheet total has not really changed, the composition has changed dramatically - instead of short-term loans for distressed assets, the Fed has been gobbling up mortgage backed securities helping to make all the other distressed assets in the world look a lot less distressed.

5. Energy Prices Will Rebound

After dipping below $30 a barrel in the spring, the price of crude oil will rise to $100 by the time Hurricane season is over (hey, there's no election in '09) and end the year at $85.

Just when people were getting used to $1.50 gasoline, taking advantage of dealer incentives to buy Suburbans and Escalades again, the price at the pump will be back up over $3 and they won't be happy about it.

Grade: A-

The spot price of crude oil dipped well below $40 a barrel, but not below $30, and the rebound did come, though it never reached the century mark. Nonetheless, the year-end price of $79.36 a barrel was close enough to the predicted $85 price that this probably merits a grade of excellent.

Gasoline prices never made it back to $3 a gallon, but given that they were about a dollar higher at the end of the year than at the beginning (about $2.60 vs. $1.60), a lot of people are probably scratching their heads about how the oil bubble burst, yet they're still paying about 50 percent more at the pump than they did just a few years ago.

6. Gold and Silver Will Soar

The price of silver will double before ending the year at around $20 an ounce and gold will again surpass the $1,000 mark, finishing the year at $1,150. Inventory at the SPDR Gold Shares ETF will increase to over 1,000 tonnes and there will be 10,000 tonnes of silver in the iShares Silver Trust ETF. We still won't be sure whether the ETFs really have the metal, but no one will care.

An increasing number of retail investors will buy gold and silver for the first time and they'll sell in a panic during the first correction they encounter. They'll look back and think, "Precious metals are no more volatile than that S&P500 Index fund I sold last year. Why did I sell in a panic again? Maybe I should just invest in Hummels."

People will start talking about junior mining stocks at cocktail parties - just like internet stocks in 1997. (As noted the last couple years, I'm going to keep saying this until it's true).

Grade: A

The silver price almost doubled - from $11 an ounce to $19 an ounce late in the year - and it ended at about $17 while gold did again charge through the $1,000 an ounce mark in September to end at around $1,090 an ounce.

Both of these were deemed good enough that another 'A' is being awarded.

The inventory at the world's largest gold ETF rose from 780 tonnes at the beginning of the year to over 1,134 tonnes in June and ended the year at just a hair below that mark. However, the volatile silver ETF inventory fell short of the 10,000 tonne mark at about 9,500.

I don't think 2009 was the year that people started "talking about junior mining stocks at cocktail parties just like internet stocks in 1997", but 2010 might be.

7. The U.S. Economy and its Consumer Engine will Hit Rock Bottom

The personal saving rate will rise to four percent and both layaway programs and Christmas savings clubs will grow in popularity. This won't be good for the U.S. economy which will contract during the first two quarters and post anemic growth rates in the last two.

Much of the Christmas savings money will be raided late in the year as many consumers will think they've served their penance and, with money gushing out of the government and central bank, they will regain their spendthrift ways before year-end making for a spectacular Christmas shopping season as compared to the one that just concluded.

Grade: A

Savings rate - check. Layaway programs - check. GDP in Q1 and Q2 negative - check. Anemic growth in Q3 - check. Money gushing from Washington and the central bank - check.

As for a regaining their spendthrift ways before Christmas, that appeared to be limited to those items that were accompanied by a government stimulus check.

It looks like the 2009 holiday shopping season will be an improvement over the 2008 period, but not a spectacular one and an unexpected resurgence in the American consumers' spendthrift ways is one of the more frequently heard "outlier" predictions for 2010.

8. Reported Inflation will Dip into Negative Territory

We'll hear lots of talk about deflation as the overall Consumer Price Index dips into negative territory on a year-over-year basis by mid-year. At this point, we'll all be bathing in a virtual government money shower as policymakers desperately try to avoid the ignominious honor of being the first group to ever cause real deflation within a fiat money system (no, what Japan had was not real, hard-money style deflation - that was just baby-deflation).

The policymakers will succeed.

By the time the leaves start falling, we'll all be talking about inflation again as energy prices rise in what will look like an inverse, smaller magnitude version of what happened last year.

Grade: A

Deflation arrived in the consumer price index but it didn't amount to much - about -2 percent on a year-over-year basis at its worst, almost completely due to the comparisons against mid-2008 gasoline prices of over $4 gasoline.

The latest reading on inflation from the Labor Department was +1.9 percent and this is likely to go higher in a couple weeks when today's $2.60 a gallon gasoline is compared to last year's $1.60 a gallon fuel and, of course, the economists will say to ignore the influence of volatile energy prices even though, technically, the real Fed funds rate will be about -2 percent.

Predicting inflation is going to get very interesting in the next few years...

9. Four Million Jobs will be Lost

Nonfarm payrolls will decline by three million in 2009 and there will be downward revisions of about one million to prior years' payrolls data as the Labor Department grapples with its birth-death modeling once again, publicly confessing that it has utterly failed to provide any meaningful statistics about the labor market in real time.

Health care will be the only employment sector that adds jobs in 2009.

Teenagers all across the country will become disillusioned after having lived their formative years during the biggest financial bubble in the history of Mankind and then seeing it come to an abrupt end as home equity withdrawals are relegated to the history books. They will actually go out and seek work, though few will find any this year.

Grade: A+

Wow. Including the early-2009 benchmark revisions, the latest Labor Department data says that 4.1 million jobs were lost during the first 11 months of the year and Friday's monthly report is expected to be flat.

That looks like it deserves an 'A', particularly since the education and health care category was the only category to add jobs during the year.

That last paragraph about teenagers was pretty funny - just don't tell it to a teenager.

10. Websites will not Wise-Up

A growing number of websites will continue to annoy readers by automatically playing video clips when the page is opened (didn't we already go through this process about four years ago?). They'll believe their marketing staff that this really is an effective advertising technique, but they will fail to understand just how many readers are leaving, never to return, after having to search so many times for that damn Pause button.

Grade: C

There was some progress here, but not nearly enough.

Summary

Overall, this was quite an improvement over last year and ranks right up there with 2006 and 2007 - I gave myself a 'C' on that last one just so it wouldn't look like an 'A' grade was automatic, but that was quite a roll towards the end there.

For the record, it will go down as 6-As, 2-Bs, and 2-Cs, though others might not have been so lenient in some areas.

Predictions for 2010 are in progress...

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Pimco lightens up on U.S. debt

Investment managers at the fourth branch of the Federal Government, otherwise known as Pacific Investment Management Co. or Pimco, have reduced their exposure to government debt in anticipation of rising interest rates. This Bloomberg report has the details:

Bill Gross, who runs the world’s biggest bond fund, cut government debt holdings and boosted cash to the most since Lehman Brothers Holdings Inc. collapsed in 2008 amid increasing speculation that interest rates will rise.

Gross, who manages the $199.4 billion Total Return Fund at Pacific Investment Management Co., increased cash to 7 percent in November from negative 7 percent in October, according to Pimco’s Web site. The fund can have a so-called negative position by using derivatives, futures or by shorting. He reduced government-related securities to 51 percent from a five-year high of 63 percent in October.
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Gross also cut holdings of mortgage securities to 12 percent, the lowest since Pimco’s figures started in 2000, from 16 percent, according to the Web site.

Gross told CNBC on Dec. 7 that Treasuries are overvalued compared to potential inflation.

The folks at Pimco are generally early on calls like this, but they're almost always right (remember how they pleaded for Bernanke to cut rates in 2008-2009?) all the more reason to lighten up on both Treasuries and the modern day equivalent - mortgage backed securities.

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Have you seen M3 lately?

For all the talk about inflation appearing sometime in our not-too-distant future and, according to Milton Friedman, rising prices still being a monetary phenomenon, you sure don't hear too many people talking about the broadest measure of the money supply - M3.
Reconstructed over at nowandfutures for about the last three years after the Federal Reserve discontinued it, much to the chagrin (or, maybe, delight) of those conspiracy minded individuals who viewed the move as a cover-up on the grandest of scales, it's hard to see how consumer prices are going to be bid higher anytime soon, given a chart like the one above.

Of course, if banks ever start lending some of their massive reserves, an entirely different dynamic could quickly develop and the recent trend could quickly reverse, but, fortunately, our central bank leaders have assured us that they're on top of that particular situation.

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Prices rise, "deflation" nearly averted

The Labor Department reported that consumer prices rose more than expected last month, largely due to higher prices for automobiles and rising energy costs, and the year-over-year inflation rate moved back toward zero after spending nearly all of 2009 in negative territory as shown below.The government's measure of inflation rose 0.3 percent in October after an increase of 0.2 percent in September, the ninth monthly increase in prices so far this year after three months of plunging prices late last year, again, largely due to energy.

After sinking as low as -1.9 percent (on a seasonally adjusted basis) at mid-year, the annual inflation rate has now recovered to just -0.2 percent and is likely to move into positive territory next month, remaining there well into next year as energy price comparisons from year ago levels will produce some rather large percentage gains, that is, unless the price at the pump tumbles from its current level.

The 1.5 percent gain in energy costs last month, paced by an increase of 1.6 percent in gasoline prices, put the year-over-year change in the closely watched energy index at -14.0 percent in October, up sharply from many months of readings at -20 percent or more, and this is likely to produce a positive number when the November data is reported next month.
Aside from energy, there is little excitement in the inflation data these days as consumer prices still appear to be under control, the downside now well protected by the government's proxy for the cost of home ownership - the nefarious owners' equivalent rent - which stubbornly refuses to go down despite home prices that have been falling for years.

Owners' equivalent rent now shows an annual increase of 1.2 percent, a result that is clearly at odds with other homeownership costs.

Rental costs are also reported to be up 1.2 percent from last year but, given all the anecdotal accounts of landlords bending over backwards to attract tenants and reports of falling rental costs in most of the country, this seems to be at odds with the reality on the ground as well.

Of course, that seems to be standard operating procedure for the government inflation data.

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In-flation, not de-flation, in the U.K.

In a preview of coming attractions for the U.S. Labor Department, the U.K. government announced that, for the first time in nine months, the annual inflation rate has a "plus" sign in front of it, largely due to comparisons against plunging energy prices a year ago.

This story in the Telegraph provides the details:

UK inflation rises for the first time since February
Inflation rose for the first time in eight months in October in what economists say is the start of a string of increases as fuel costs climb across the economy.

The Consumer Price Index (CPI) - the measure used by the Bank to set interest rates - is now 1.5pc higher than a year ago, thanks in part to the steep fall seen in oil prices a year ago. City experts had forecast that CPI would climb to 1.4pc. October's rise was also spurred by a jump in the price of second-hand cars and the rising cost of air fares.

Economists now expect inflation to rise over the coming months as the sharp decline in energy prices and fuel costs that followed in the months after the collapse of Lehman Brothers are not repeated.

The absolutely insane fixation on "consumer prices" by central banks around the world as the predominant factor in formulating monetary policy (to the near-exclusion of everything else) is going to take on a whole new level of absurdity over the next four or five months.

It's one thing to have zero percent interest rates when annual inflation is also zero, but, if consumer prices are up two, three, or even four percent from a year ago, that means zero percent short-term rates translate to real interest rates of minus two, three, or four percent.

If asset prices are still rising come January, February, and March when the worst of the year-over-year comparisons will be reported, economists are going to have a lot of 'splainin to do, as Ricky often told Lucy.

A three percent reading for inflation appears to be more likely than not, at least in the U.K.

"So it is up, up and away," said Alan Clarke, an economist at BNP Paribas. "I think we'll get to 3pc or above by January. Everyone knows this is coming, the Bank of England included, and last week they said 'don't read to much into it, we can't control near term inflation.'

The broader measure of inflation known as the Retail Price Index (RPI), which includes the cost of housing, is still 0.8pc lower than a year ago.
Experts remain divided on how big a threat inflation will be over the next 12 months given the increase in unemployment, the pressure on people's wages and the 6pc contraction in the economy since the recession began.

The Bank has slashed rates to a record low of 0.5pc and pumped £200bn into the economy in an effort to ward off the threat of deflation - or a sustained fall in prices.

James Knightley of ING Financial Markets said: "given the spare capacity in the economy, there's no real need to tighten monetary policy anytime soon."

Comforting words about "spare capacity" and, in the U.S., an "output gap" that is still quite large are not likely to have the desired effect on those fearful of rip-roaring inflation given all the money printing that's occurred over the last year.

If economists thought the last year was tough, the year ahead might be even more difficult.

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More fodder for the inflation-deflation debate

Those thinking that we've seen the last of inflation for a while might want to have a look at what gasoline prices have been doing lately, that is, relative to a year ago. For the second straight week, the national average for the price at the pump was higher than a year ago.
It may not look like much now, but, next month the comparisons will be done against gasoline that sold for as little as $1.61 a gallon last December. Some quick math indicates that the most recent national average of $2.69 a gallon would represent an increase of 68 percent.

This will show up in the inflation data before long, however, at the moment it looks like the year-over-year increases in energy prices may be offset, at least in part, by falling rents.

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Marc Faber on the U.S. dollar and stimulus

Gloom, boom, and doomster Marc Faber made the rounds yesterday talking about the future of the U.S. dollar and the news wasn't good - something about its value going to zero, over time, in this talk with Ricky Cash at Bloomberg

He's still clearly in the "hyperinflation" camp, but not just yet because of the near-term oversold condition for the U.S. currency.

On Bernanke: "He's a money printer. He does that well."

At Reuters the topic of discussion is the U.S. economic stimulus program where the prognosis is not good either - something about government spending being inherently inefficient at getting an economy going again and ultimately leading to much higher levels of debt and then much higher interest rates.

You have to wonder whether there's anyone in the Obama administration who pays any attention to this sort of commentary.

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Paul Volcker is making sense

How many people listen to former Federal Reserve Chairman Paul Volcker these days? Sadly, the answer to that question is probably "far too few", however, that doesn't stop him from speaking his mind as reported by Reuters yesterday.

The enormous amounts of liquidity pumped into the U.S. financial system by the Federal Reserve are not inflationary "at the moment" but will become so at some point, Paul Volcker, the former Fed chairman and a White House adviser, said on Thursday.

Volcker, now an economic adviser to President Barack Obama, said it was difficult, but necessary, to start draining the billions of dollars in liquidity even while unemployment rates remained high as the U.S. battles out of recession.

"You have to act against what seems like common sense. If you wait, it's too late," Volcker said while answering questions after a speech on financial markets at Harvard University's Kennedy School of Government.
...
Financial markets have not yet fully healed, he said, and the economy remains plagued by structural imbalances that threaten to prevent a sustainable recovery taking hold from the deep recession.

"We have to regain our ability to produce goods. Moving money around does not necessarily provide dinner on the table," Volcker said. "You can't run an economy where the financial sector is making 40 percent of the profits."

It's too bad that more powerful voices (and personalities) in the Obama White House have caused Volcker to be largely ignored in recent months.

ooo

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No COLA for you!

You'd think that if the Consumer Price Index were really doing what it was supposed to do (i.e., accurately reflecting changes to the cost of living in the U.S.), there wouldn't be a need for the government to provide aid to senior citizens when the inflation index says none is required. Yet, that's exactly what's happening as indicated in this report on the big lump of coal being placed in millions of stockings this winter by the Social Security Administration.

There will be no cost of living increase for more than 50 million Social Security recipients next year, the first year without a raise since automatic adjustments were adopted in 1975, the government announced Thursday.

Blame falling consumer prices. By law, cost of living adjustments are pegged to inflation, which is negative this year because of lower energy costs. Social Security payments do not go down, even when prices drop.

The Obama administration, meanwhile, is pursuing a different way to boost recipients' income. On Wednesday, President Barack Obama called for a second round of $250 stimulus payments for seniors, veterans, retired railroad workers and people with disabilities.

This $250 payment would effectively be a one-time cost of living adjustment of two percent following an increase of almost 6 percent earlier this year, a boost that was driven by soaring energy prices in 2008.

If the government were to be more honest about this, they'd construct an inflation index for senior citizens as one British newspaper has done in recent years. There, the age 65+ inflation rate comes in at 2x or 3x the "overall" inflation rate since seniors spend a disproportionate amount of their money on medical costs, energy, and food, making far fewer purchases of items that have been going down in price such as electronics and apparel.

Claims such as this one somehow fail to ring true:

"Social Security is doing its job helping Americans maintain their standard of living," said Social Security Commissioner Michael J. Astrue.

But, he added, "In light of the human need, we need to support President Obama's call for us to make another $250 recovery payment for 57 million Americans."

Again, there's something clearly wrong with the logic there.

Of course that doesn't mean that it won't get repeated enough times that people actually start to think that their personal experience in the world is somehow the exception to the rule.

Social Security recipients shouldn't get a raise next year because their purchasing power has already increased with falling consumer prices, said the Center on Budget and Policy Priorities, a liberal-leaning think tank.

"Since the purpose of COLAs is to preserve beneficiaries' purchasing power, the decline in overall prices means that beneficiaries do not need a COLA in January 2010," Kathy Ruffing, a senior policy analyst at the center, wrote in a report this week.

Over the past 12 months, gasoline prices have fallen 29.7 percent and overall energy costs have decreased 21.6 percent, the Labor Department said Thursday.

Things could get very interesting this winter if energy prices remain elevated, something that appears increasingly likely with each passing week.

In mid-December of 2008, gasoline cost only $1.61 a gallon and current prices of about $2.50 a gallon represent an increase of more than 50 percent. That's going to be a tough argument to counter if seniors begin complaining loudly about getting stiffed later this year.

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Maybe economic theory is wrong

I've been meaning to go back and revisit this piece about one of my favorite subjects over the years - owners' equivalent rent - but have so far failed to do so. This first appeared here on September 04, 2008, just over a year ago.

In looking up some data for the previous post on initial jobless claims, this little FAQ about the Consumer Price Index was stumbled upon at the Labor Department. It doesn't say how long it's been there, but it was apparently updated today.

Here's the part that explains the rationale for owners' equivalent rent being included in the inflation statistics in lieu of anything having to do with actual home prices.

The CPI used to include the value of a house in calculating inflation and now they use an estimate of what each house would rent for -- doesn't this switch simply lower the official inflation rate?

No. Until 1983, the CPI measure of homeowner cost was based largely on house prices. The long-recognized flaw of that approach was that owner-occupied housing combines both consumption and investment elements, and the CPI is designed to exclude investment items. The approach now used in the CPI, called rental equivalence, measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes.

The rental equivalence approach is grounded in economic theory, receives broad support from academic economists and each of the prominent panels, and agencies that have reviewed the CPI, and is the most commonly used method by countries in the Organization for Economic Cooperation and Development (OECD). Critics often assume that the BLS adopted rental equivalence in order to lower the measured rate of inflation. It is certainly true that an index based on home prices would be more volatile, and might move differently from other CPI indexes over any given time period. However, when it was first introduced, rental equivalence actually increased the rate of change of the CPI shelter index, and in the long run there is no evidence that the CPI method yields lower inflation rates than some other alternatives. For example, according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.

The approach is grounded in economic theory that may be looked back upon someday as one of the greatest blunders in the history of economics - kind of like after the Great Depression when Austrian Economics, popular at the time, was discredited for the rest of the century.

And that last part about the National Association of Realtors - that probably needs a little looking into. Something smells awfully fishy about that conclusion.

Also see: The complete and utter failure of owners' equivalent rent

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UPDATE - Sept 4th, 10 PM PST

I was going to put this in the comments section but figured it would be better here...

I verified that OER from 1983 to 2007 has risen 140 percent.

The January 1983 median home price was $73.5K which, with a 90% LTV 30-year fixed loan at 13.25% works out to a PITI of $745 per month.

The January 2007 median home price was $254.4K which, with a 90% LTV 30-year fixed loan at 6.22% works out to a PITI of $1405 per month.

This works out to an increase of about 90 percent, which is close enough to the 79 percent figure cited by the BLS, so there's no need to call them.

This is more a story of interest rates than it is anything else and what's much, much more important than the last 25 years is the last ten years or so. It could be that OER worked well for the first ten years or so until we got "innovative" financing in the last decade. For example, a quick check shows OER increased 29 percent from 1997 to 2007 but mortgage payments increased by about twice that amount.

I'll do a follow up on this sometime soon. As long as the BLS and NAR brought this up and seemed to poo-poo the whole idea of a flawed OER, I'm now curious to see how PITI versus OER looks like over time - my guess is that you'll see a big disconnect between the two once interest rates leveled out in the late 1990s and home prices took off.

Sources:
Census Bureau Home Prices (.pdf)
Federal Reserve Interest Rates

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A slack attack in Bend, Oregon

The sharp transition from boom to bust in our new home town of Bend, Oregon is apparently so interesting these days that the Wall Street Journal saw fit to send a couple reporters out here to have a first hand look (maybe doing a little hiking, kayaking, or golfing in their spare time), resulting in the following Page 1 story($) in today's paper.

Slack Attack: Fed Faces Test on Inflation
By SARA MURRAY and JON HILSENRATH
BEND, Ore. -- Tens of thousands of people who moved here in the past decade saw a booming real-estate market and plentiful jobs amid the mountains of Central Oregon. Now they see slack.
A year and a half of recession has left local manufacturer Bright Wood Corp. with too much capacity at its plants that make window and door components. Bright Wood has laid off nearly half of its work force, shut an 80,000-square-foot factory in Bend, and sold or stored its extra equipment.

Additional underutilized industrial space, housing and workers are apparent across town. More than 9,000 people have lost jobs since mid-2006. Some 29% of homes are vacant. "For Lease" signs hang on store windows near the town's main drag, Wall Street.

Maybe that was part of the attraction for these two New Yorkers - the town's two main streets are named Wall and Bond.

From here, they go on to talk about "slack" in the economy and how that might relate to deliberations about inflation at this week's FOMC meeting which is an odd combination to be sure - Bend, Oregon and the Federal Reserve - but one that makes good sense to me for obvious reasons.

As for inflation, there would appear to be so much "slack" around here these days that no one should be too concerned about the price of anything going up for some time.

Slack is important to their equation because, in theory, it should suppress wages and prices and keep inflation down. But if the Fed misreads the dimensions or significance of slack, it could unleash an unwelcome bout of rising prices.

The risk of inflation is significant. The federal government is running budget deficits on a scale last seen during World War II, while the Fed has pumped more than $800 billion into the banking system. Banks haven't been lending this money freely so far, but once they start, it could spur economic activity and send prices rising. One signpost of gathering inflationary fears is that the price of gold, often seen as a hedge against inflation, has soared by more than 40% since last October to more than $1,000 an ounce.

Yeah, might as well throw gold into the mix while they're at it - a trifecta!

They also mention foreclosures, which, I guess if you write about Deschutes County today, you have to cover that topic. The number of default notices tripled in the last two years and more than half of the modest number of sales in August were distressed sales.

And they note that the FDIC was here not long ago to have a close look at the books kept by Bank of the Cascades, one of the areas largest banks with a loan committee that probably made a few too many construction loans a few years back.

These two probably won't be the last East Coast reporters to stop by here to see what some now refer to as the "poster child" for the housing boom gone bust.

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