Cumberland Advisors Market Commentary – Inflation, Deflation, and Capacity Utilization – Part 2

Bloomberg’s Lisa Abramowicz recently tweeted, “When you measure the prices of things Americans are spending money on right now, ‘it turns out that the actual inflation rate is not as low’ as the data suggest” (https://twitter.com/lisaabramowicz1/status/1263868020516151298). Her evidence was a chart showing how spending for food at home had jumped while spending on food away from home had declined significantly. But it turns out that it isn’t enough to look only at prices of individual items. We must also consider what weight they get in computing overall inflation.

Market Commentary - Cumberland Advisors - Inflation, Deflation, and Capacity Utilization – Part 2

The Dallas Fed has just released its April trimmed mean PCE inflation rate, which is touted as a measure of the overall movement of inflation based upon the Bureau of Economic Analysis’ Personal Consumption Expenditures Index (PCE). What is unique about the measure is that it throws out the extreme monthly movements of prices on both the high side and low side. Of the approximately 178 components examined (note that the BLS considers 300 such components in computing the CPI), it totally omitted 62 components with the highest increases and 60 components with the largest price declines. The measure compares the annualized one-month rate, 6-month rate, and 12-month rate with both the BEA’s PCE Index and PCE ex food and energy (https://www.dallasfed.org/research/pce). Below is a snapshot of those comparisons.

What are we to learn from this comparison? First, the trimmed mean tells a more benign story about the most recent monthly change than do the sharp declines in the PCE and PCE ex F&E. Second, that conclusion is reversed when we look at the 6-month comparisons and a more concerning story on a 12-month basis. So what should we conclude? The monthly story showing the annualized data says this is what the inflation rates would be if the monthly changes were to persist for the next 12 months. Do we really believe that prices will decline each month for the next 12 months as they did in April? In the current environment, it is highly unlikely that this will be the case. The one-month percentage change in the trimmed mean PCE would be only 0.42%. Similarly, the year-over-year comparisons show a much higher rate of inflation for the trimmed mean PCE than for the other two measures. When we seek to make sense of these differences, we find that the devil is in the details and especially in what we are willing to assume about inflation dynamics. Do we believe that all prices move together, or do some prices lead and some lag? If the latter is true, then the trimmed mean throws out critical information about inflation dynamics. If we don’t, then the trimmed mean throws out monthly noise.

Fortunately, the Dallas Fed also publishes the detail behind its calculations. The detail shows annualized monthly changes for some 178 components together with their weights. The component with the highest percentage increase was eggs, which increased 497.2% in price. This instance illustrates how misleading the reported change is using annualized numbers, since no one believes or can reasonably assert that the price of eggs will increase that much over the next year. The one-month percentage increase April was 16.1%, which compares with a 2.8% increase in March. On an annualized basis the March increase would translate to 39%, but we know that figure is unlikely to be a good representation of inflation dynamics. It is also worth noting that the price of eggs gets only a weight of 0.12% in the index. The item with the greatest weight in the index for April, as was the case in March, is the imputed cost of an owner-occupied home, which accounted for 14.2% of the index in April. That cost showed a 2.1% increase for the month. In the case of the trimmed mean, the excluded components whose prices declined accounted for 24.3% of the weight in the PCE; the included portion accounted for only 44% of the index; and the excluded items with price increases accounted for 32% of the trimmed mean. That said, it is interesting that of the 178 components in the trimmed mean PCE Index, 93 actually showed increases; 6 had no change; and 79 showed price declines. Finally, of the top 10 items that are experiencing the largest price increases and that have the greatest weight in the index, 7 are food-related, one is prescription drugs, and one is paper products (no surprise there). Together, these 10 items added only 20 basis points to the overall PCE index produced by BEA. The 10 items which have the greatest weight in the index and which are experiencing price declines (including, for example, gasoline and men’s and women’s clothing) subtracted 60 basis points from the overall index.

So the picture that emerges is not as clear as Lisa Abramowicz’s tweet would have us believe. The prices of some goods that are important to people, like certain foods, have gone up, while the prices of other goods and services, like gasoline, have declined. Furthermore, it is also clear that the dynamics of those price movements are due to significantly different factors. Food prices at grocery stores have gone up as a result of increased demand, in part because of trends like hoarding and eating at home instead of at restaurants, and in part because of disruptions that COVID-19 has caused in the supply chain. On the other hand, the decline in gasoline prices is due to the Saudi/Russian jousting over production, which has been exacerbated by declines in demand in the US as people have cut back on driving. In short, it is important to look at the detailed data and not to extrapolate one-month price changes and then annualize them as if they will persist for an entire year.

(Part one of this discussion was published on May 22, 2020 here: https://www.cumber.com/cumberland-advisors-market-commentary-inflation-and-capacity-utilization/)

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


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Cumberland Advisors Market Commentary – Inflation and Capacity Utilization

At Cumberland, we continuously have internal strategy discussions. We decided to make one such discussion, on the subject of inflation and US capacity utilization, available in the form of a commentary to clients, consultants, and all readers. Below you’ll find a summation of our discussion, written by Bob Eisenbeis, Cumberland Advisors Chief Monetary Economist. -David Kotok


Inflation, Deflation, and Capacity Utilization

by Bob Eisenbeis

Market Commentary - Cumberland Advisors - Inflation, Deflation, and Capacity Utilization

During the pandemic we have seen both a drop in aggregate demand as well as a shutdown in supply, resulting in a precipitous drop in capacity utilization. To many economists, this convergence means that inflation will be benign in the foreseeable future. We know that excess demand serves to bid up prices, but is there reliable information on the supply side in terms of capacity utilization that also conveys meaningful information about price pressures as well? To address this question, it is useful to look at the long-run relationship between capacity utilization (blue) and inflation (red). In the 1970s, capacity utilization appeared to increase, followed by an increase in inflation. The pickup seemed to start when capacity utilization exceeded 80%.

Inflation and capacity utilization chart 01

The idea is that, as demand increases, businesses expand their productive capacity; increase labor hours; and then, ultimately, increase prices and invest to expand capacity to meet the increased demand.

However, in the period following the two recessions in the early 1980s, the relationship appears to have broken down, and that breakdown continued up to almost the current period, when capacity utilization declined to slightly below its low point in late 2009. To investigate the capacity utilization-inflation relationship, we computed linear regressions for the entire 1967–2020 period as well as for the shorter 1967–1983 period, when there appeared to be a strong relationship between capacity utilization and inflation. Interestingly, for the entire period, the strongest regression incorporated a three-month lag between changes in capacity utilization and inflation; but even for this regression, changes in capacity utilization explained only about 18% of the variation in inflation. For the shorter period, the regressions were much weaker, explaining at most 1.5% of the variation in inflation.

The large drop in capacity utilization in 2008 and 2009 was accompanied by a drop in inflation, but it is unlikely that there was a causal relationship between the two trends, since we know that the problems were in the housing and financial sectors. You will also note a slight downward trend in capacity utilization from about 1995 to the present. It becomes a bit clearer when we look only at the period from 1988 to the present, in the following chart.

Inflation and capacity utilization chart 02

Again, we need to remember that this was a period of low inflation and steady growth. In general, if businesses expect growth to continue, they will invest and expand capacity in anticipation of that growth, thereby contributing to lower measured capacity utilization in the short run. Business investment from late 1985 through 2007 averaged 5.4% year-over-year growth with a standard deviation of 6.8 percentage points. By comparison, business investment has only grown by 2.8% quarterly year-over-year since 2016 as the economy experienced slower growth; and, logically, slower investment followed. Over that period, capacity utilization averaged about 77%, whereas it averaged over 81% from 1988 through 2009.

This historical analysis raises the question of whether the monetary expansion undertaken by the Fed will prevent some business failures and support consumption in the short run. The monetary expansion should help create the opportunity to dampen the downturn, moderate the number of business failures and resulting loss of capacity, and thus facilitate a faster return. The key is whether a vaccine is discovered, tested, produced, and administered quickly around the globe. We saw how the market responded last Tuesday to the announcement of an experiment with only eight people.

Right now, capacity utilization has slumped to about 65%, according to the most recent number. That decline is due in part to a precipitous drop in demand, but also to production facilities shutting down. That capacity has not been destroyed, but rather it has been idled. We know that larger businesses, such as auto manufacturers, are ramping up production again; and the ability to bring those facilities on-line will depend upon demand. But the capacity will be destroyed only if a significant number of businesses fail. So, we need to watch business failures, as well as how quickly capacity utilization increases. We should also not expect business investment, except in the residential sector, to be an important contributor to growth.

The key to the inflation forecast is how quickly aggregate demand increases and whether it will outstrip supply. Thus, the economy’s longer-term growth prospects hinge, after this crisis has passed, on growth in productivity and growth in the labor force. Right now, the two indicators combined imply a real rate of growth of about 1.2% to 1.4%, which is not all that different from the low inflation environment we experienced during the recovery from the 2008 financial crisis. To the extent that this scenario plays out, it suggests that we should see next to no inflation for at least two or three years, or perhaps even longer.

(Part two of this discussion was published on June 03, 2020 here: https://www.cumber.com/cumberland-advisors-market-commentary-inflation-deflation-and-capacity-utilization-part-2/)

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentary – Inflation/Deflation: What Do We Know Now?

The most recent CPI numbers show a decline of 0.8% for the month of April, triggering questions about both a possible deflation and where prices are likely to go in the future. The fact is that no one knows what inflation will do in the short run, and all we have to go on, as yet, is fragmentary evidence that might suggest which of the competing hypotheses is more likely to be correct.

Cumberland Advisors' Robert "Bob" Eisenbeis, Ph.D.

The most recent data, aside from the headline CPI figures and some rough breakdown of components for April, are in the March components that make up the CPI. April data show some key components that have accelerated while others have declined. For example, the following chart from BLS shows the sharp decline in energy prices, while not surprisingly, food has increased significantly.

Food to be eaten at home was up more than was food to be purchased from restaurants; and of that, meats and poultry were up the most, followed by dairy products. All these segments have been negatively impacted by supply chain disruptions, creating shortages in the face of increased demand, in part related to panic hoarding and in part to the fact that more Americans have been eating at home. What is also important is to recognize that the large percentage declines are the year-over-year changes for the monthly data.
Clearly, financial dynamics have changed, and this change affects the ability of models to predict with some degree of accuracy. The monthly data for March, broken down by the Dallas Fed in computing its trimmed mean, show that 72 of the 178 components to the CPI declined a weighted cumulative total for the month of minus 33 basis points from the CPI, while the remaining 106 components added 31 basis point to the index.
Additionally, it is not clear that current events have, as yet, had a significant impact upon expectations. The chart below shows the most recent data from the Atlanta Fed’s May predictions for inflation one year ahead, based upon its survey of businesses, which is at 1.5% and unchanged from the previous month. This figure is somewhat surprising given what we know about unemployment and the virus’s impacts on the real economy
Over the longer term, the story is not much different. Those numbers show a much higher rate of inflation than we are seeing now. Here is another picture of the Atlanta Fed’s inflation expectation 10 years out (which actually isn’t very useful for the short term). This number is consistent with a much higher rate of inflation above the Fed’s target rate, a rate that hasn’t been achieved for the past 10 years or so.
Interestingly, the Atlanta Fed also publishes a set of deflation probabilities that the inflation number will be below a reference point. The following chart shows that the probability that we will experience inflation below what was expected as of April 15, 2019 (which was 2% on a year-over-year basis) has been essentially zero for the entirety of 2020, notwithstanding the pandemic.
Breaking that longer-term forecast down to components related to real return versus inflation compensation, at least for the short term, shows inflation compensation next to zero.
With regard specifically to the issue of TIPS, the Cleveland Fed shows longer-term yields essentially at zero.
The bottom line is that we are looking at inflation at or below 1% for the near term. What should we look for in terms of signals otherwise? We should focus on two dimensions – demand and supply. Supply will likely recover faster than demand will, and that difference will keep inflation pressures dampened. Without excess demand, you can’t bid up prices; and if you try to raise them, people will turn to substitutes.
What does this mean for the term structure? Again, the following chart shows recent data on the term structure from the Cleveland Fed. Short-term for the next three years, we see rates below or possibly at 1%.

The wild card in all this is that we don’t know what the Treasury financing needs will be and how much upward pressure they will put on rates. How much of that will end up on the Fed’s balance sheet, and how much crowding out will this result in? If we get another $3 trillion in government spending, what will this do to rates? And this is in an environment with little or no inflation.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Cumberland Advisors Market Commentary – Central Banks, Capital Markets, Debt/Deflation, Real Income Growth, Interest Rates & Housing

We wrapped up our Labor Day Camp Kotok with a round of excellent on-the-record discussions that we’re happy to share with you here.

Camp Kotok - Big Lake - Stacked Stones - Conversations from Camp Kotok

David Kotok and Charles Plosser at Camp Kotok: The Challenges Facing Central Banks
David Kotok and Christopher Whalen at Camp Kotok: Capital Markets, Debt and Deflation
David Kotok and Doug Duncan at Camp Kotok: Real Income Growth, Interest Rates and Housing

See more interviews and content at Cumberland Advisors’ YouTube Channel:
https://www.YouTube.com/CumberlandAdvisors


David Kotok and Charles Plosser at Camp Kotok:
The Challenges Facing Central Banks

Long-time friends David Kotok, Chairman and Chief Investment Advisor of Cumberland Advisors, and Charles Plosser, Retired President of The Federal Reserve Bank of Philadelphia, take a moment on Labor Day Weekend at Camp Kotok to chat about the role of central banks looking towards the future. Plosser encourages current governments and economic policy makers to be realistic in their expectations of the power of Central Banks to solve all problems.

Central banks are not a panacea, Plosser warns, adding, political pressure is undermining the independence of central banks around the world and their ability to focus on long-term solutions. He cautions that the reliance on central banks to be problem solvers can lead to unconventional policies resulting in unintended consequences—that can be difficult to unwind. Plosser remains optimistic about the remarkable resiliency of the American system of government and our free market economy.

Charles Plosser served as president and CEO of the Federal Reserve Bank of Philadelphia from 2006-2015 when he retired. He is a visiting fellow at the Hoover Institution at Stanford University.


David Kotok and Christopher Whalen at Camp Kotok:
Capital Markets, Debt and Deflation

David Kotok, Chairman and Chief Investment Advisor of Cumberland Advisors interviews Christopher Whalen.

“I have confidence in America’s capital markets,” Whalen said. At the same time, he expressed concern about debt and related deflation in Europe and Asia focusing on the central banks unsuccessful attempts to fix the continuing 10-year crisis. Discussion covers negative interest rates in Europe, America’s ability to heal the crisis in non-bank markets, fishing and French Bordeaux.

Richard Christopher Whalen is an investment banker and author who lives in New York City. He is Chairman of Whalen Global Advisors LLC and focuses on the financial services, mortgage finance and technology sectors.


David Kotok and Doug Duncan at Camp Kotok:
Real Income Growth, Interest Rates and Housing

David Kotok, Chairman and Chief Investment Advisor of Cumberland Advisors interviews Doug Duncan Fannie Mae’s senior vice president and chief economist about his outlook for housing. Duncan acknowledges strong labor force participation noting that new additions to employment are gradually slowing. New jobs are needed to keep unemployment numbers down. Real income growth in the lower tier is rising and low interest rates are fueling refinancing. Duncan is concerned about the impact of tariffs and trade discussions curbing incentives for companies to invest in a global economy. He explains that, “Investment is the driver of productivity gains, and productivity gains are the driver of real income growth, and if people are going to buy a house, real income matters.”

Kotok asks if America might see the negative interest rates that are in Europe now. Duncan responds. “I am hopeful that the fact that the US is still growing, at about 2% growth, is going to be sustained long enough to lead the rest of globe back to …a rational view of interest rates.” Kotok and Duncan remain optimistic about the US economy, fishing, friendship and good wine.

Doug Duncan is responsible for providing all forecasts and analyses on the economy, housing, and mortgage markets for Fannie Mae. Duncan also oversees corporate strategy and is responsible for strategic research regarding external factors and their potential impact on the company and the housing industry.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.AAA