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What is the US Fed’s Kashkari smoking?

He says there are zero signs of inflation.

Incredibly, in November the president of the Minneapolis Federal Reserve, Neel Kashkari said that there is no sign of rising inflation and that the US central bank should hold off on raising interest rates until that changes.

I am amazed that a person with such high standing in one of the most influential decision-making units in the world, a member of the Federal Open Market Committee (FOMC) in the USA, should be so oblivious to the ground-swell change that is currently occurring. No doubt his vision will colour his voting at the up-coming FOMC meeting – the last over which the current chair, Janet Yellen, will preside before handing over to Jerome Powell, assuming that President Trump’s choice will be approved by the Senate.

Bear in mind that a rise (or not) in interest rates in the USA affects South Africa materially. What happens in Vegas, stays in Vegas: but what happens to interest rates in the USA does not stay in the USA.

As a developing country, we run significant deficits on our current account – spending more than we earn as a country. We borrow from foreigners to fill that gap: either directly, or persuading them to invest in SA. Currently, most of that is in the form of portfolio flows, rather than direct investments and a good deal of that is into our bond market.

Important, for us in South Africa, is the relationship between our interest rates and those in the USA.  The generally accepted model is that the US 10-year bond yield is the ‘base’, to which is added SA’s ‘risk premium’.  The benchmark bond used for this in SA is the R186 that matures in 2026, so is not quite a 10-year bond. The R186 gap, or risk premium, between the two yields has recently been stable at around 6.5%. So if the US 10-year yield were to go 3.5% (about 1% higher than it is now), we could be looking at 10% for the R186. 

Similarly, it is difficult to see a set of circumstances in which the SA Reserve Bank is reducing rates when the FOMC is raising them. That affects the prime overdraft rate and that, in turn, affects all borrowers in SA, of which there are many.

Higher inflation in the USA – or at least recognition of the dangers of it increasing – is likely to have a serious effect on our economy, which is in a pretty parlous state as it is.

So we have to consider what would make them raise rates. Without doubt, the main driver is inflation. So a recent Reuters article that quotes Neel Kashkari saying that there are zero signs of rising inflation in the USA, raised some eyebrows.

But is Kashkari correct in his observation?

We know that in many major countries, South Africa excluded, inflation has been all but dead for a number of years; in fact until recently, the bogey of “deflation” was touted by many central bankers.

The questions that need to be asked and answered are:

  • What is his definition of inflation?
  • How is it measured?
  • Are there any signs to watch for in the likely future trajectory of “inflation”?

It has been standard practice at the FOMC (as gleaned from the published minutes) to refer not only to inflation defined as the rate of change in the Consumer Price Index but also to “core inflation” and also to “wage inflation”.

The following chart is from www.tradingeconomics.com:

 

Source: www.tradingeconomics.com

The surprise here is that a 2% inflation rate, seen by the FOMC as a precursor to a rate rise, was seen in December 2016 when they did, indeed, increase the interest rate, embarking as they put it, on a rate-tightening cycle. The following months disappointed but now we can see a rising trend. The question is what is causing this and is it likely to continue?

For that we need to understand the weights of the main constituents of the index: the following chart is from www.bls.gov.

 

Source: www.bls.gov

For a South African it is nearly incomprehensible that 42% of the average USA consumer’s expenditure is on Housing and another 15% on Transport. Even more astonishing, although it has now crept into the South African basket that is measured for changes in price level, is the weighting within Housing of “Owners’ equivalent rent of primary residence” at 23.5% of the total. What is that? How often does it change? Clearly, it is not something that can be measured by going to your local supermarket or at the petrol pump. This changes with house prices and particularly with the interest charged on home loans. So, essentially, a large part of the ‘cost of living’, that CPI inflation is designed to measure, has been static in the US for a number of years and, in any case, is unlikely to exhibit large spikes or troughs. No wonder Kashkari sees zero inflation in something like that.

Transport, on the other hand, is affected by the cost of fuel. The weighting for “Motor fuel” is 3.4%. That may seem low to SA motorists but bear in mind that the ‘average’ consumer often uses trains, buses and other forms of transport to get around. For this discussion it is important to note that the oil price is up 40% from its low in June this year. No inflation? C’mon, Kashkari. The actual pump price of motor fuel is not directly related just to the oil price – there are other factors such as refining margins, transport costs and inventory costs but eventually, if the oil price stays where it is, it will impact more than the 10% price increase shown for “Gasoline”, which is what Americans call ‘petrol’. Of course, the impact is much more likely to be felt and seen in Producer Price Inflation.

 

That is already starting to show pricing pressure: while 2.6% may not sound frightening to us in SA, it is the highest figure for a long time in the USA. Zero inflation visible? More likely hiding in plain sight.

The other major area is food at 15%. The remarkable story for this – which is why looking at ‘inflation’ and puzzling why there is so little ‘wage inflation’ is not a useful exercise for decision-makers at the FOMC – is that for YEARS now, many food items, notably grains and dairy products, have been at low levels. It has been calculated that the ‘American breakfast’ now costs the same as it did in 2008.

 

Source: http://www.macrotrends.net/2534/wheat-prices-historical-chart-data

 

Look carefully: the price of wheat has only been lower than current a few times in the last 10 years.

Will this change any time soon? That seems unlikely, despite the fact that the world population is now rising rapidly in numbers if not percentage terms. What could make it change, apart from weather? The leading countries by production are:

Rank

Country

Production (1000 MT)

 

1

EU-27

151 039.00

 

2

China

130 000.00

 

3

India

98 380.00

 

4

Russian Federation

82 000.00

 

5

United States

47 371.00

 

6

Canada

27 000.00

 

7

Ukraine

26 500.00

 

8

Pakistan

26 200.00

 

9

Australia

21 500.00

 

10

Turkey

21 000.00

 

11

Argentina

17 500.00

 

12

Iran

15 000.00

 
         

Of course, many of these countries have large domestic demand.

As can be seen in the following table, very few of the major wheat exporting countries are currently experiencing political or other economic difficulties that could lead to a sudden halt to their exports (with the possible exception of the Ukraine).

Below are the 10 countries that exported the highest dollar value worth of wheat during 2016:

  1. United States:    US$5.4 billion                    (14.8% of total wheat exports)
  2. Canada:                $4.5 billion                         (12.4%)
  3. Russia:                 $4.2 billion                         (11.6%)
  4. Australia:             $3.6 billion                         (9.9%)
  5. France:                 $3.4 billion                         (9.3%)
  6. Ukraine:               $2.6 billion                         (7.2%)
  7. Germany:            $1.9 billion                          (5.3%)
  8. Argentina:           $1.9 billion                          (5.1%)
  9. Romania:             $1.3 billion                          (3.5%)
  10. Poland:                 $0.8 billion                         (2.2%)

 

Looking further afield, the Bank of England has recently raised interest rates for the first time in more than ten years, largely as a result of the (annual) inflation rate reaching 3%, affected by the pound being weak following the Brexit vote.

 

We all know that Japan is labouring under “deflation” or “disinflation”, as it has for decades, right?  Right!  Look at the chart below:

 

Not a negative rate in sight, Neel, and at 0.7% (very low by our standards), the highest in many years.  Look further at Producer Price Inflation:

 

Yes, there are some negative scores just over a year ago but 3% now??  Wow.  Any minute now the Bank of Japan may notice – but will they react by raising interest rates? From the current -0.1% (yes, a negative rate, as it has been since early 2016).

 

Unlikely, if you believe their current policy and stance which is that of a late-starting “Quantitative Easing” policy in which the BoJ has difficulty in finding assets to purchase, even being allowed to buy Exchange Traded Funds. Imagine the shock if they raise it to zero which it was from late 2010 to 2015.

In summary then: there are enough cases for us to query the sources used by the Minneapolis Federal Reserve Bank president, Neel Kashkari, who is also a voting member on the FOMC, when he says that he sees zero signs of inflation – and recommends putting off a further rise in interest rates until he does.

Liston Meintjes is portfolio manager at NVest Securities in Johannesburg.

COMMENTS   1

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The US exports inflation, so the levels measured within the US are artificially low. In addition, the US Fed, like the RSA SARB, has intentionally reconstituted and rebalanced its basket so as to reduce the reported figure. This was done so as to take actions favorable to the financial sector (wallstreet), at the expense of the man in the street (mainstreet).

One of the main reasons this was done, was to justify the zero interest rate policy, which was required in order to prevent the big financial players from having to declare bankruptcy. Now that these players have been able to off-load that debt onto taxpayers and other useful fools, it is safe for them to raise interest rates, and exit the ZIRP environment.

In order to justify raising rates, inflation has to be seen to be low (this is counter-intuitive to classical monetary theory, but who cares, right) – and if rates are not raised from the current effective zero bound, then who knows wtf the fed is going to be able to do in the next scientifically engineered depression.

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