The Consumer Price Index (CPI) rose by 0.5% in December, a sharp rise from the 0.1% increase in November, and the 0.2% rise October. While that sounds bad, year over year it is up just 1.5%.
Looking a little bit deeper, the problem is mostly with energy prices, which surged 4.6% a very sharp acceleration from the 0.2% increase. Actually, November was more like a pause in the trend as Energy prices were up 2.6% in October and are up 7.7% year over year.
In fact, the increase is even narrower than that, as energy commodities such as gasoline were up 7.5% after increases of 0.8% in November, 4.4% in October and 1.8% in September. Year over year energy commodity prices are up 13.9%. That is much higher than inflation in the rest of the economy.
The relative pricing strength in energy commodities suggests that it would be a good idea to be over weighted in the energy sector. Energy service prices like electricity and piped gas service rose by just 0.5%, and that is after they actually fell by 0.7% in November, and after rising by 0.2% in October. In September energy service prices fell by 0.8%.
Year over year, energy services prices are down 0.1%. In other words, the pain is at the pump, not in the plug.
Food prices were also relatively well behaved, up 0.1% on top of rising just 0.2% in November after being up 0.1% in October and 0.3% in September. Year over year, food prices are up 1.5%. Due to poor harvests in several important areas of the world, most notably due to droughts in Russia, and floods in Pakistan and Australia, agricultural commodity prices have been rising sharply. So far they have had relatively little impact on Consumers shopping at Kroger's (KR).
The actual cost of raw wheat is a very small fraction of the actual cost of a loaf of bread, so one would not want to exaggerate the likely impact of higher prices in the commodity pits on prices at the checkout counter. That is not as true elsewhere in the world, and rising food prices have already started to cause unrest in some countries.
Core Inflation
Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up 0.1%, matching the November increase, and that is after three straight months of being unchanged. Year over year, core prices are up 0.8%.
Over the last six months, the increase annualizes to 0.6%. While everyone consumes food and energy, their prices tend to be extremely volatile, and can be influenced by external events. As such, the Fed tends to focus more on core prices when setting monetary policy. After all, it would not be a good idea to be tightening up on the money supply or raising interest rates simply because there is a drought in a key agricultural area of the world which drives up food prices, or because there is instability in the Middle East which causes energy prices to rise. Together, food and energy make up just 22.3% of the total CPI.
The graph below tracks the long-term history of the CPI (year over year change) on both a headline and a core basis. Note that core CPI is at an all-time low for the period on the graph (and I cut out the really high inflation 1970's so you could get a better sense of the more recent movements). The year-over-year change in core CPI is at just off its record low level of 0.6% set in October, and records go back to 1957.
Another Vindication for QE2
This report is a vindication of the Fed decision to undertake another round of quantitative easing. The danger of QE2 is that it could set off a round of inflation -- many critics say hyperinflation. That, however, is not the danger the economy faces, deflation is.
Deflation is a very nasty beast, and one that the Fed must stop from emerging at all costs. At any given level it is far more insidious than inflation; we can and have done reasonably well as an economy with 3 or 4% inflation, but 3 or 4% annual deflation would be an economic nightmare. For starters, nominal interest rates do not go below 0.0%, which means that real interest rates would rise sharply. That will choke off capital investment in the economy.
At the same time, if people know that prices are going to be lower in the future than they are now, they will sit on their wallets. Total demand would fall. With no customers since they are all sitting and waiting for prices to go down, businesses will have even less reason to invest and would have need of fewer employees. The resulting layoffs would result in still less aggregate demand. Lather, Rinse, Repeat.
Housing Prices Staying Low
The key reason why the core CPI has been so low of late is the cost of shelter. Housing prices are not measured directly through a housing price index like the Case-Schiller index. Instead, the government tries to measure just how much it would cost you to rent a house equivalent to the house you own next door to it.
This is known as Owner's Equivalent Rent (OER). It makes up 25.21% of the CPI, or more than food and energy combined. Regular rent, paid by tenants to landlords makes up another 5.97% of the overall CPI. The two rent measures tend to move closely together and combined make up 31.2% of the overall CPI, and since you neither eat nor burn your house (unless you are an arsonist committing insurance fraud) they make up an even larger part of the core CPI, 40.1%.
Regular rent rose 0.2% in December, matching the November increase. That is after rising just 0.1% in both October and September. Over the last year it is up just 0.8%. OER was up just 0.1%, matching its November and October increases, but that is after being unchanged in each of the previous two months. Year over year, OER -- by far the most important single part of the CPI -- is up just 0.3%.
The use of OER rather than directly tracking housing prices makes for a much more stable CPI. If housing prices were directly measured, so using the Case-Schiller index, inflation early in the decade would have been running at levels close to what we saw in the 1970's, and over the past few years as the housing bubble burst, we would be experiencing severe outright deflation in the core CPI.
Right now, the risk of deflation is greater than the risk of runaway inflation. We are not in it yet, at least as measured by core prices, but we are uncomfortably close.
The threat of deflation is one of the reasons that long-term T-note yields are so low. Even after the recent bounce, a return of under 3.4% per year is not very enticing for locking up your money for ten years. If inflation were to average over the next ten years, what it has averaged over the last ten years (2.5%) the increased amount of goods and services you could get for delaying your gratification for a decade would be almost nothing.
At the first hint that inflation is picking up, bond yields can be expected to head much higher. Even though I think that deflation is a greater threat right now than a return to the high inflation of the 1970's, I do not think that the Fed will allow it to happen. QE2 is aimed directly at preventing that from occurring.
Deflation is the only scenario under which the purchase of long-term treasuries makes sense at these levels. To buy a T-note, you have to be rooting for breadlines and Hoovervilles. A good way to bet on T-note yields rising is the Short Treasury ETF (TBT).
Where Prices Are Increasing
So what areas are showing price increases? Health Care costs always seem to run faster than overall inflation, but even they seem relatively well behaved. Medical commodity prices (i.e. drugs) were up just 0.1% in December after being up 0.2% in November and rising 0.1% in October. Year over year they were up 2.9%.
Part of the reason for that is probably the increasing substitution of generic drugs for name brand prescriptions. While the drugs are still on patent, firms like Pfizer (PFE) and Merck (MRK) are still aggressively raising prices, but they are now losing share to their slightly older drugs that are no longer state-enforced monopolies and have to face the free market.
Medical Services prices (i.e. a visit to the hospital) rose 0.3% on top of an increase of just 0.1% in November. In October the cost of seeing a doctor, or going to the hospital was up 0.2%. Year over year, medical service prices are up 3.4%.
Yes, health care costs are still higher than the inflation rate elsewhere in the economy, but is far below the average rate of medical inflation in recent years (decades). The differential between the increase in health insurance costs and actual medical inflation suggests that margins should increase significantly for the major HMOs like United Healthcare (UHC).
The taming of medical inflation is vitally important, as rapidly rising health care costs are the primary factor in the long-term structural budget deficit. It is the long-term structural deficit that we have to be worried about, not the current big deficit that is mostly due to cyclical factors (reduction in tax revenues and higher automatic stabilizer costs due to high unemployment).
The other noteworthy area of inflation, at least on a year-over-year basis, had been in car prices, particularly used car prices. That finally changed for the better in September, as they fell 0.7%. That continued October with a 0.9% decline, and the downward trend continued in November with a 0.5% decline. The rate of decline moderated to 0.1% in December.
Still, we are talking about a 3.7% rise over the last year. The price of new cars was unchanged after they fell 0.4% in November and were down 0.2% in October. Year over year, new car prices are down 0.2%. In other words, the remarkable resurgence in the Auto industry was not simply due to the car companies being able to jack up prices.
The differential between new and used car prices was obviously unsustainable. If it were to continue for a few more years, a 1999 Ford (F) Escort would cost more than a new Ford Focus. Somehow I don't see that happening. The narrowing of the difference is probably bad news for the big used car dealers like CarMax (KMX).
What we were probably seeing is a large “inferior good” effect: in tough times, people gravitate to buying the cheaper product, even if is of inferior quality. Used cars relative to new cars meet that description.
Overall this was a fairly solid report. The headline number looked a bit scary, and it was a tick higher than the expected 0.4%. Core inflation though and even food inflation remains very tame. The report does not totally put to bed the danger of deflation, but is a step in that direction.
QE2 should be bearish for the dollar (and thus bullish for other currencies) but so far the effect seems to have been swamped by renewed concerns over the Euro due to the Irish (and potentially Portuguese and Spanish) debt situation. QE2 should end the risk of outright deflation and at the margin should help the overall economy. Don't expect it to have a dramatic effect.
The major incremental stimulus comes from the payroll tax reduction. That should be fairly effective, as most of that money will be going to people who earn less than $106,000 per year. Those folks are more likely to spend it than save it.
For someone earning $50,000 per year (about the median income), it is an additional $1,000 after tax in their pockets. That money will mostly be spent fairly quickly, although some of it may go to paying down debt and the repair of battered balance sheets. Paying down debt is healthy in the long run, but does little to help in the near term.
FORD MOTOR CO (F): Free Stock Analysis Report
CARMAX GP (CC) (KMX): Free Stock Analysis Report
KROGER CO (KR): Free Stock Analysis Report
PFIZER INC (PFE): Free Stock Analysis Report
UNITEDHEALTH GP (UNH): Free Stock Analysis Report
Zacks Investment Research
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In fact, the increase is even narrower than that, as energy commodities such as gasoline were up 7.5% after increases of 0.8% in November, 4.4% in October and 1.8% in September. Year over year energy commodity prices are up 13.9%. That is much higher than inflation in the rest of the economy.
The relative pricing strength in energy commodities suggests that it would be a good idea to be over weighted in the energy sector. Energy service prices like electricity and piped gas service rose by just 0.5%, and that is after they actually fell by 0.7% in November, and after rising by 0.2% in October. In September energy service prices fell by 0.8%.
Year over year, energy services prices are down 0.1%. In other words, the pain is at the pump, not in the plug.
Food prices were also relatively well behaved, up 0.1% on top of rising just 0.2% in November after being up 0.1% in October and 0.3% in September. Year over year, food prices are up 1.5%. Due to poor harvests in several important areas of the world, most notably due to droughts in Russia, and floods in Pakistan and Australia, agricultural commodity prices have been rising sharply. So far they have had relatively little impact on Consumers shopping at Kroger's (KR).
The actual cost of raw wheat is a very small fraction of the actual cost of a loaf of bread, so one would not want to exaggerate the likely impact of higher prices in the commodity pits on prices at the checkout counter. That is not as true elsewhere in the world, and rising food prices have already started to cause unrest in some countries.
Core Inflation
Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up 0.1%, matching the November increase, and that is after three straight months of being unchanged. Year over year, core prices are up 0.8%.
Over the last six months, the increase annualizes to 0.6%. While everyone consumes food and energy, their prices tend to be extremely volatile, and can be influenced by external events. As such, the Fed tends to focus more on core prices when setting monetary policy. After all, it would not be a good idea to be tightening up on the money supply or raising interest rates simply because there is a drought in a key agricultural area of the world which drives up food prices, or because there is instability in the Middle East which causes energy prices to rise. Together, food and energy make up just 22.3% of the total CPI.
The graph below tracks the long-term history of the CPI (year over year change) on both a headline and a core basis. Note that core CPI is at an all-time low for the period on the graph (and I cut out the really high inflation 1970's so you could get a better sense of the more recent movements). The year-over-year change in core CPI is at just off its record low level of 0.6% set in October, and records go back to 1957.
Another Vindication for QE2
This report is a vindication of the Fed decision to undertake another round of quantitative easing. The danger of QE2 is that it could set off a round of inflation -- many critics say hyperinflation. That, however, is not the danger the economy faces, deflation is.
Deflation is a very nasty beast, and one that the Fed must stop from emerging at all costs. At any given level it is far more insidious than inflation; we can and have done reasonably well as an economy with 3 or 4% inflation, but 3 or 4% annual deflation would be an economic nightmare. For starters, nominal interest rates do not go below 0.0%, which means that real interest rates would rise sharply. That will choke off capital investment in the economy.
At the same time, if people know that prices are going to be lower in the future than they are now, they will sit on their wallets. Total demand would fall. With no customers since they are all sitting and waiting for prices to go down, businesses will have even less reason to invest and would have need of fewer employees. The resulting layoffs would result in still less aggregate demand. Lather, Rinse, Repeat.
Housing Prices Staying Low
The key reason why the core CPI has been so low of late is the cost of shelter. Housing prices are not measured directly through a housing price index like the Case-Schiller index. Instead, the government tries to measure just how much it would cost you to rent a house equivalent to the house you own next door to it.
This is known as Owner's Equivalent Rent (OER). It makes up 25.21% of the CPI, or more than food and energy combined. Regular rent, paid by tenants to landlords makes up another 5.97% of the overall CPI. The two rent measures tend to move closely together and combined make up 31.2% of the overall CPI, and since you neither eat nor burn your house (unless you are an arsonist committing insurance fraud) they make up an even larger part of the core CPI, 40.1%.
Regular rent rose 0.2% in December, matching the November increase. That is after rising just 0.1% in both October and September. Over the last year it is up just 0.8%. OER was up just 0.1%, matching its November and October increases, but that is after being unchanged in each of the previous two months. Year over year, OER -- by far the most important single part of the CPI -- is up just 0.3%.
The use of OER rather than directly tracking housing prices makes for a much more stable CPI. If housing prices were directly measured, so using the Case-Schiller index, inflation early in the decade would have been running at levels close to what we saw in the 1970's, and over the past few years as the housing bubble burst, we would be experiencing severe outright deflation in the core CPI.
Right now, the risk of deflation is greater than the risk of runaway inflation. We are not in it yet, at least as measured by core prices, but we are uncomfortably close.
The threat of deflation is one of the reasons that long-term T-note yields are so low. Even after the recent bounce, a return of under 3.4% per year is not very enticing for locking up your money for ten years. If inflation were to average over the next ten years, what it has averaged over the last ten years (2.5%) the increased amount of goods and services you could get for delaying your gratification for a decade would be almost nothing.
At the first hint that inflation is picking up, bond yields can be expected to head much higher. Even though I think that deflation is a greater threat right now than a return to the high inflation of the 1970's, I do not think that the Fed will allow it to happen. QE2 is aimed directly at preventing that from occurring.
Deflation is the only scenario under which the purchase of long-term treasuries makes sense at these levels. To buy a T-note, you have to be rooting for breadlines and Hoovervilles. A good way to bet on T-note yields rising is the Short Treasury ETF (TBT).
Where Prices Are Increasing
So what areas are showing price increases? Health Care costs always seem to run faster than overall inflation, but even they seem relatively well behaved. Medical commodity prices (i.e. drugs) were up just 0.1% in December after being up 0.2% in November and rising 0.1% in October. Year over year they were up 2.9%.
Part of the reason for that is probably the increasing substitution of generic drugs for name brand prescriptions. While the drugs are still on patent, firms like Pfizer (PFE) and Merck (MRK) are still aggressively raising prices, but they are now losing share to their slightly older drugs that are no longer state-enforced monopolies and have to face the free market.
Medical Services prices (i.e. a visit to the hospital) rose 0.3% on top of an increase of just 0.1% in November. In October the cost of seeing a doctor, or going to the hospital was up 0.2%. Year over year, medical service prices are up 3.4%.
Yes, health care costs are still higher than the inflation rate elsewhere in the economy, but is far below the average rate of medical inflation in recent years (decades). The differential between the increase in health insurance costs and actual medical inflation suggests that margins should increase significantly for the major HMOs like United Healthcare (UHC).
The taming of medical inflation is vitally important, as rapidly rising health care costs are the primary factor in the long-term structural budget deficit. It is the long-term structural deficit that we have to be worried about, not the current big deficit that is mostly due to cyclical factors (reduction in tax revenues and higher automatic stabilizer costs due to high unemployment).
The other noteworthy area of inflation, at least on a year-over-year basis, had been in car prices, particularly used car prices. That finally changed for the better in September, as they fell 0.7%. That continued October with a 0.9% decline, and the downward trend continued in November with a 0.5% decline. The rate of decline moderated to 0.1% in December.
Still, we are talking about a 3.7% rise over the last year. The price of new cars was unchanged after they fell 0.4% in November and were down 0.2% in October. Year over year, new car prices are down 0.2%. In other words, the remarkable resurgence in the Auto industry was not simply due to the car companies being able to jack up prices.
The differential between new and used car prices was obviously unsustainable. If it were to continue for a few more years, a 1999 Ford (F) Escort would cost more than a new Ford Focus. Somehow I don't see that happening. The narrowing of the difference is probably bad news for the big used car dealers like CarMax (KMX).
What we were probably seeing is a large “inferior good” effect: in tough times, people gravitate to buying the cheaper product, even if is of inferior quality. Used cars relative to new cars meet that description.
Overall this was a fairly solid report. The headline number looked a bit scary, and it was a tick higher than the expected 0.4%. Core inflation though and even food inflation remains very tame. The report does not totally put to bed the danger of deflation, but is a step in that direction.
QE2 should be bearish for the dollar (and thus bullish for other currencies) but so far the effect seems to have been swamped by renewed concerns over the Euro due to the Irish (and potentially Portuguese and Spanish) debt situation. QE2 should end the risk of outright deflation and at the margin should help the overall economy. Don't expect it to have a dramatic effect.
The major incremental stimulus comes from the payroll tax reduction. That should be fairly effective, as most of that money will be going to people who earn less than $106,000 per year. Those folks are more likely to spend it than save it.
For someone earning $50,000 per year (about the median income), it is an additional $1,000 after tax in their pockets. That money will mostly be spent fairly quickly, although some of it may go to paying down debt and the repair of battered balance sheets. Paying down debt is healthy in the long run, but does little to help in the near term.
FORD MOTOR CO (F): Free Stock Analysis Report
CARMAX GP (CC) (KMX): Free Stock Analysis Report
KROGER CO (KR): Free Stock Analysis Report
PFIZER INC (PFE): Free Stock Analysis Report
UNITEDHEALTH GP (UNH): Free Stock Analysis Report
Zacks Investment Research
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