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Sunday, October 30, 2011

The CPI Food and Energy Debate

Occasionally I see something that annoys me so much that I feel the need to respond to it in a blog post.  Today, it was that I saw people on a message board saying that the Consumer Price Index (CPI) no longer includes food and energy so you shouldn't pay attention to it.  There are some legitimate criticisms of how CPI is calculated, but this isn't one of them.  The headline CPI number does include food and energy, but economists are usually more interested in the so-called "core" CPI rate, or the change in prices excluding food and energy.  The reason that they prefer this measure is that it isn't as driven by possibly arbitrary changes in commodity prices.  If inflation is truly endemic, it will show up in less volatile prices because wages are likely also inflating at a rapid rate, pushing up the prices of more stable goods as well as services.

Some have also wondered if over time the two come out more or less the same.  After all, according to some, inflation and food and energy is always faster than other prices so if you follow core inflation only you are missing the story.  Well, not really:

For most of the years after 1981, core CPI actually outpaced total CPI because energy and food prices were quite sedate while health care costs went through the roof.  Since the mid 1990s, however, it is true that total CPI has outpaced core inflation.  In fact, the compounded annual growth rate (CAGR) of total CPI vs core CPI has been 0.5% a year higher than core inflation since September 2000.  Still, what history would suggest is that these two will not diverge by a great deal for that long.

Now, as to the volatility, adding food and energy does add a great deal of volatility.  The average monthly inflation rate of both measures over the past 54 years is about 0.32%, but the standard deviation for the total CPI is a full 0.06% higher than for the core CPI.  It might not sound like a lot, but it does matter.

So no, there isn't some evil conspiracy behind excluding food and energy.  In truth, I look at both anyway as alternative measurements.  It doesn't take too long and there isn't much harm in doing it.

The European Debt Crisis: Was the Rescue Package Enough?

The stock market's initial reaction appears to offer the answer of "yes", but then again we saw fairly convincing rallies early on in the financial crisis in 2007 (as I always like to remind people, our problems began in the summer of 2007, not 2008).  Equity markets often give false signals, perhaps more frequently than other markets.

As of right now, it does not appear that European debt markets are buying into the program here.  For instance, we have not seen Italian bond yields gap down:

The same troubling thing holds true in Portugal:

There rates are down a touch, but still nothing noticeable, considering that they are trading close to 1,000 basis points above German 10-year bonds.

The issue, as I see it, is a similar one to what we went through in 2009.  Let's back up for a moment here and state clearly why sovereign debt defaults are important to us: they threaten the health of major banks.  That's the whole reason that even more stable countries live in mortal fear of a Greece or a Portugal going under.  Banks like buying sovereign debt for their reserves due to its low default rate.  If the debt they buy becomes distressed so they have to mark it down or if the borrowers default, that undermines the banks' capitalization and they need to, at best, issue more shares to recapitalize, which dilutes the value of existing shareholders.  In a worst case scenario, the whole rotten thing comes crashing down and the banks fail catastrophically.  I think that we all know the consequences that stem from that scenario.

As such, just like the situation we faced in early 2009, this is about whether the banks can reasonably attain enough capital to recapitalize to offset massive losses coming down the pike.  In our case, it was the continuing doubts over the mountains of bad mortgages that banks were carrying on their books above the likely value that they could realize those assets at.  Investors speculated for weeks and months about just what kind of hits our banks would have to take and it caused our markets to go into a total tailspin that took the Dow down to 6,500 at one point.  Just an aside, there is no rational model by which one can call that a fair price for the market at that point.  What came along to really solve the issue were the stress tests of our banks that detailed the amounts our banks needed to raise in additional capital in order to survive two differing economic scenarios.  While there was criticism over the rigor of the tests at the time, it really did prove to be a turning point, along with expansionary monetary and fiscal policy that had begun just before that.  They put a number on how much the banks would have to raise and investors could use that figure to pivot their decision making on whether or not to buy shares.  Before that point, it had been somewhat of an unknown.

The markets had already begun a recovery before the release of the test results in May 2009 (the bottom was March 9th), including a massive rally in bank shares, but as the year went on, the financial stocks eventually added another huge leg to their rally in the summer as the recapitalizations went along without much incident.  From then on in, the markets regained confidence, and things began to return to some level of normalcy.  There were many other measures taken, so I don't want to exaggerate the importance of the stress tests, but the point is that once the health of the banks was assured, the markets and the economy at large could move on.

The key to Europe is whether the banks will now be sufficiently recapitalized.  The stress tests there have been of questionable credibility, often only focusing on macroeconomic conditions and not pricing in what would happen with large write-downs of sovereign debt.  That has started to change in the most recent iterations, but some analysts think that the stress tests are low-balling the needed capital by as much as $200 billion.  As long as investors are not convinced that the banks' balance sheets are now as secure as the Maginot Line... wait a moment... as unsinkable as the Titanic... as solid as the walls of Constantinople... erm, well, pretty safe, we will be prone to a renewed crisis.

Of course, history may well show that this was the turning point and many of the naysayers have been wrong. After all, credit spreads here did not really start coming in until a full month after the stock market bottomed in March of 2009.  (CLICK ON IMAGE FOR LARGER PICTURE)


Spreads did not begin their true downward trajectory until early to mid April and did not actually reach quasi-normal levels until October.  In other words, it could be a while before we really know.  At this moment, I am doubtful that we have seen the last of this crisis.

The 1998 Time Warp

One of my earliest memories of following the financial markets was the meltdown in 1998 caused by the Russian Debt Default and the subsequent collapse of Long Term Capital Management.  It was the most severe and sustained collapse in equity prices that I'd ever seen, which wasn't that impressive since I was only 12, but it still left a mark on me.

For that reason, I am struck by how similar the bottoming process in the stock market looks now to what it looked like then. (CLICK ON IMAGE FOR LARGER PICTURE)

The scale of the rout this year is also very comparable at about -19% from peak to trough and the rally is happening at about exactly the same time and at very nearly the same trajectory.

However, while history does tend to rhyme, it doesn't fully repeat and the next verse can be very different from the first.  There are considerably more risks now than there were, at least immediately, in 1998.  Also, as I will address in my next post, the European bailout package just does not seem to be of the magnitude necessary to completely dispel the considerable worries of the financial markets.  However, the equity markets were so terribly undervalued at their most recent bottom that the present rally is fully warranted.

Getting Back Into the Swing of Things

Due to slavish commitments at work and all manner of other nonsense, I took a bit of a hiatus, but now I should be posting fairly regularly again.  It's a fascinating time to come back into it, so hopefully there will be some good posts to come.