The financial arrangements of the state are no longer sustainable…government will NOT voluntarily let itself go out of business…it will use all its powers available to government to fund itself.
-Former Fed Governor and National Economic Council Director Larry Lindsay, May 2015
When it becomes serious, you have to lie.
-Jean Claude Juncker
Is the government gaming with the inflation data? Here is what John Mauldin thinks.
Beginning with the January print due for release on 14th February, the ‘BLS (Bureau for Labor Statistics) plans to update the spending weights in the calculation of the CPI (Consumer Price Index) every year instead of every 2 years. Spending weights indicate what share of total expenditures each item represents.’ They claim that ‘This change will improve the relevance of CPI spending weights by using the most recent consumer spending information. By improving the relevance of spending weights, BLS can improve the accuracy of the CPI.’
“Maybe so but because the comparisons are very high using just one year, the CPI figures over the next 12 months will come in lower than otherwise. In the press release the BLS literally said ‘we hope you will love’ the new ‘improvement’ but making this vital economic stat no longer apples to apples for the next 12 months, I don’t really love it but the Fed will because it will make the inflation gauge lower than it would have been.
Without getting into the weeds, for the next year and maybe more, year-over-year comparisons on different segments of the inflation constellation are simply going to look better, or that’s the theory. As Yogi Berra said, “In theory, it works. In practice it doesn’t.”
The reason that this is so important is that on past occasions when the government, via its various agencies, has decide to “manipulate” economic data the markets have gone on a significant tear.
Back in April 2009 as the GFC (the Great Financial Crisis) was in its final stages the US accounting standards board the FASB decreed that banks did not have to apply mark to market rules to their distressed assets because of frozen markets. In other words, they didn’t have to value their loan book on a fire sale basis. These changes helped drive the KBW bank index to triple off the lows that year, despite the fact that no one really knew exactly how these accounting changes would translate to bank earnings, loan growth, economic growth, etc. The only point the market cared about was that the FASB and by extension, the US government had just made “extend and pretend” official US policy.
Similarly in January 2016 as 15 months of oil price declines were wreaking havoc on the US shale energy sector, related banks, industrial companies, and the US economy and markets more broadly the Dallas Fed quietly suspended energy mark-to-market on default contagion fears.
Despite the denials from various quarters, the market did not wait to try to figure out the quantitative earnings impacts for energy companies, for banks with energy exposure, for US industrial production, or for the broader US economy. The XOP (oil and gas E&P ETF) rose 60% until December 2016 and the rest of the market followed suite.
Like suspending mark-to-market accounting for banks and energy companies, if changing the CPI methodology can result in lower-than-expected inflation for the next few months, it could be a game changer for markets – rates, currencies, stocks, bonds – all of them. Why? As Luke Gromen puts it,
Lower-than-expected reported CPI cuts the Gordian Knot of the US government’s increasingly intractable fiscal situation, at least for 1-2 quarters. Lower-than-expected reported CPI for the next 3-6 months would check a lot of boxes for a US government that is staring into the abyss of a 2023 fiscal crisis. If we are right, then “goal-seeked, below-expected reported inflation” has now effectively become official US policy. If so, in our view, the best way to position for this is to position as if the Fed increased its inflation targets, because there is little functional difference between changing methodology to get reported inflation below expectations and raising inflation targets.
As ever, in life and the world of finance, there is no such thing as a guarantee. The assumption is that the CPI data comes in well below estimates and the Fed reacts by not raising rates any further. They will most likely be at 4.75% after the FOMC meeting on 1st February but that will be it. They may hold rates there for a while but if the inflation numbers continue to surprise on the downside there may be room for them to start reducing rates again by the end of Q2.
This doesn’t gel with recent comments by Powell about staying the distance and comments by new voting members of the FOMC well summarised by Helen Thomas at Blonde Money
A new year brings a new set of FOMC voters, with Bullard, Collins, George and Mester rotating off and Kashkari, Logan, Harker and Goolsbee coming in. Although the departing group are considered more hawkish than the former, the new kids on the voting bloc have recently been deploying their hawkish plumage:
- Kashkari’s January blog post was at pains to explain it’s on hold or higher once the interest rate peak has been reached:
- “Once we see the full effects of the tightened policy, we can then assess whether we need to go higher or simply remain at that peak level for longer”.
- Harker added that even with rates on hold, Quantitative Tightening will effectively tighten monetary conditions:
- “At some point this year, I expect that the policy rate will be restrictive enough that we will hold rates in place to let monetary policy do its work. We are also shrinking our balance sheet, which is removing a significant amount of accommodation in and of itself”.
- Logan warned that if financial markets don’t believe their commitment to fight inflation, the Fed will have to raise rates further:
- “We can and, if necessary, should adjust our overall policy strategy to keep financial conditions restrictive even as the pace slows”.
As Logan went on to say “a slower pace could reduce near-term interest rate uncertainty, which would mechanically ease financial conditions. But if that happens, we can offset the effect by gradually raising rates to a higher level than previously expected”. Given Logan has extensive market experience from her time running the NY Fed QE portfolio, her voice will become increasingly important in the year ahead. Expect Powell to suggest some FOMC members considered 50bp this week and that hikes remain on the table even when the peak is reached.
Over in Europe the ECB’s Lagarde is also hawkish if not more so.
Lagarde rebuked the markets on January 19. Investors are underestimating the ECB’s commitment, she said. Investors should “revise their position. They would be well-advised to do so,” she said.
And similarly at the BoE
Catherine Mann is sticking to her hawkish guns and voted for 75bp at the last meeting. In her 11 meetings on the MPC (Monetary Policy Committee) she has voted for hikes larger than the consensus 5 times. When she spoke at the Bank of England Watchers Conference at the end of last year she was at pains to point out that “if there was a policy mistake (not raising rates fast enough), it’s not my fault”.
On the one hand we have the Bureau for Labor Statistics about to move the goal posts and on the other a coterie of central bankers determined to “stick it out” until the inflation dragon is banished. If the Fed continue with their foot on the loud pedal and we get two more rate rises in March and May, then the increasing supply of US Treasuries, as tax receipts and foreign buying continue to subside and Fed Quantitative Tightening is on the increase, may well lead to a dysfunctional bond market. That is the Fed’s dilemma. Slay inflation or bankrupt the US economy. To reiterate Larry Lindsay’s observation
Government will NOT voluntarily let itself go out of business…it will use all its powers available to government to fund itself.
The FOMC decision, and more importantly the tone of the press conference following their meeting, will determine the markets’ immediate reaction. We get the first iteration of the “new, improved” CPI data on the 14th February. Will we get a repeat of 2009 and 2016? Let’s watch.