Inflation Still Tame - Analyst Blog

The Consumer Price Index (CPI) rose by 0.3% in July after declining in each of the previous three months. While this was slightly higher than the 0.2% that was expected, it is still a very tame reading. On a year-over-year basis, consumer prices are up just 1.2%. Most of the increase in July was due to higher energy prices; most importantly, higher gasoline prices. Overall energy prices rose by 2.6% in the month, reversing sharp declines in June, May and April. Energy commodities had the sharpest increase (and previously had suffered the biggest declines) with a 4.0% rise. Gasoline was up 4.6%. The price of energy services, such as electricity, also rose, but by a tamer 0.8%. They had suffered more modest declines in the previous three months.

On a year-over-year basis, overall energy prices are up 5.2% with energy commodity prices up 8.0% and energy service prices up 1.7%. Food prices declined by 0.1% in July after being unchanged in the previous two months. Food and Energy prices are among the most politically-sensitive prices, but actually make up a relatively small part of the overall consumer shopping cart tracked in the CPI. Food has only a 13.74% weight in the CPI and Energy just an 8.55% weight, with Energy commodities at 4.80%. They are, however, subject more than most areas to external shocks, such as crop failures or decisions by OPEC to expand or constrict supplies. As such, when running monetary policy, you want to exclude them.

The Fed would not want to tighten up on the money supply simply because of a drought in the Midwest, as commodities, food and energy prices tend to be more volatile than other prices. It is not because people don’t need to eat or drive that food and energy are excluded to get to the Core CPI, but because they can give misleading signals about the underlying trend of overall inflation. Core inflation is much more stable than is headline inflation as is shown in the graph below.

The core CPI rose just 0.1%, in line with expectations and up 0.9% over last year. The July increase comes on top of increases of 0.2% in June and 0.1% in May. On both a headline and core basis, inflation is at very low levels relative to recent historical experience. There does not seem to be any danger of runway inflation at this time; indeed, deflation seems to be a much bigger threat. That is certainly the message being sent by the bond market given a five year t-note yield of just 1.46%. Even if headline inflation were to stay at the rate we have seen over the last year, the real return people are getting for postponing their consumption for five years would be just 0.26% per year. Longer term rates are somewhat higher, but are still very low at 2.71% for 10 years and 3.90% over 30 years (think about how much the world has changed over the last 30 years and consider if that is a good return for locking your money up for that long into the future). The only way these yields make any sense is if a dollar is going to be able to buy more goods and services in the future than it will buy today.

Aside from the price of energy, it is hard to find areas where prices are increasing significantly. Even health care inflation has been relatively subdued of late. The price of medical commodities (i.e. drugs) fell by 0.2% in July after being unchanged in June and up only 0.1% in May. Year-over-year prices are up 3.2%. Still, outpacing overall inflation to be sure, but much lower than we have seen in recent history. The price of Medical Services (i.e. doctor office visits) was also up just 3.2% over the last year. They were unchanged in both July and May, but up 0.4% in June. If the rates of the last three months were to be sustained, medical service inflation would be just 1.6% over a year and medical commodity prices would be down by 0.4%. That might actually start to slow the increases in Health Care Insurance, but somehow I suspect that Wellpoint (WLP) and Aetna (AET) will still find a reason to increase premiums, at least until the recent health care reform provisions take full effect.

The one area that has seen consistent price increases over the last year is used cars. That is probably good news for the big dealer groups like AutoNation (AN) and CarMax (KMX). They were up another 0.8% in July on top of a 0.9% increase in June and a 0.6% increase in May. Over the last year they are up 17.0%. In contrast, new car prices are only up 0.1% in each of the last three months and up 0.9% over the last year. Who knew that the old 1999 Ford Escort that leaked oil all over your driveway was going to turn into a classic worth more than a brand new car? Well that has not happened yet, but is the logical result of what would happen if those two trends continued indefinitely. It does not seem likely to happen to me.

The biggest item by far in the CPI is the price of Shelter. Within shelter, the most important item is what is known as Owners Equivalent Rent (OER) which is what the government figures homeowners charge themselves for living in the house they own. It accounts for 25.21% of the entire CPI, and the regular rent that tenants pay to landlords (which tends to be closely related) accounts for an additional 5.97% of the CPI. Rather than use house prices, which are an asset as well as an expenditure category, they try to figure out what it would cost you to rent an equivalent house to yours next door.

OER has not collapsed the way housing prices have in the past few years, but it also did not race upwards during the housing bubble. Both OER and regular rent were up 0.1% in July and June and unchanged in May. Over the last year, OER is down 0.2% and Rent is up just 0.1%. While housing prices bounced a little in the spring due to the homebuyer tax credit, that is now over, and housing prices are likely to start to fall again - at least through the end of the year.

The Federal Reserve has, by law, a dual mandate. One is to insure price stability, and the other is to maintain maximum employment. Prices are now very stable, and indeed seem more likely to start falling than they are to take off. On the other hand, we are no where close to full or maximum employment. The decision on Tuesday to reinvest the proceeds from their mortgage portfolio into long term government bonds rather than letting the assets simply roll off is a welcome half step. However, it is not really going to be enough to get the job done. A roll off strategy would be a passive tightening of monetary policy, and a tightening is the last thing we need now. Reinvestment is not really a set towards a looser policy, but simply neutrality. While additional Fed action would be useful, monetary policy right now is going to be far less effective than fiscal policy in boosting economic growth and bringing down unemployment.

More fiscal stimulus is needed, and needed soon. Trying to balance the budget right away would be like deciding that because of the big balance on your credit card bill, you can’t afford to pay the bus fare to go to work and thus lose your paycheck. Cutting spending in an economic downturn is exactly the policy that was followed by Hoover and was a big part of the reason we ended up in the Great Depression. Later on, FDR tried to balance the budget by cutting spending too much in 1937 and the economy fell back into a recession. Those that will not learn from history are condemned to repeat it. The slowdown in health care inflation, if it can be sustained, will have a far bigger impact on the long term government debt levels than any cuts we make in stimulus spending now.

 
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