The Consumer Price Index (CPI) rose by 0.4% in April, down from its 0.5% rise in both March and February. Year over year it is up 3.2%. It was slightly below the consensus expectation of a 0.5% increase.
Looking a little bit deeper, the problem is mostly with energy, and to a lesser extent food prices. Energy prices surged 2.2% on top of a 3.5% increase in March and a 3.4% rise in February. Overall energy prices are up 19.0% year over year. Actually the increase is even narrower than that, as energy commodities, such as gasoline and heating oil were up 3.1% after an increase of 5.5% in March and a 4.8% surge in February.
Overweight Energy
Year over year, energy commodity prices are up 32.7%. 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 overweighted in the energy sector.
Energy service prices, like electricity and piped gas service, rose just 0.6% for the month. That is after a 0.2% rise in March, but a 1.1% increase in February. Energy services have generally been much more tame than energy commodity prices. Year over year, energy services prices are up a paltry 0.1%. In other words, the pain is at the pump, not in the plug. Fortunately it looks like oil prices are coming down, and so we should get a fair amount of relief in headline prices in the May report.
Food Prices Creeping Up
Food prices, which had been relatively well behaved, are starting to act up as well, though not nearly as badly as energy commodity prices. They rose 0.4% in April. That is after a 0.8% rise in March, and in February they were up 0.6%. Not something that brings a lot of smiles to the faces of shoppers at Safeway (SWY), but not exactly the end of the world either.
Year over year, food prices are up 3.2%. However, food prices at the grocery store are rising faster than restaurant prices, and those are a lot less discretionary than going out to eat. Grocery store inflation was 0.5% on top of a 1.1% rise in March, after being up 0.8% in February.
Year over year, “food at home” inflation is 3.9%. That is hardly Zimbabwe, but it is higher than the rest of the economy (especially over the last three months), and if that pace were maintained for a full year, it would be 10.0% inflation. That sort of pace would take a serious bite out of consumers wallets.
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. Many of the key agricultural futures have doubled over the last year or so. So far they have had relatively little impact on consumers shopping at Kroger’s (KR), but that might be beginning to change.
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. Or at least they provided the spark to ignite the protests in places like Tunisia and Egypt.
Core Inflation Numbers
Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up 0.2%, up from 0.1% March and matching the February increase. Year over year, core prices are up 1.3%. 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 near 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 just off its record low level of 0.6% set in October, and records go back to 1957.
Quantitative Easing Vindicated
This report is a vindication of the Fed decision to undertake quantitative easing. The danger of QE2 was that it could set off a round of inflation — many critics said “hyperinflation.”
People hyperventilating about inflation need to get a bit of historical perspective. By any realistic historical standard, inflation — even headline inflation — it quite low. Core inflation is extremely low.
Meanwhile, unemployment is extremely high. Actions taken to fight one tend to exacerbate the other, at least in the short to medium term. Over the long term, higher inflation can be detrimental to employment, but we are nowhere near that point. Personally, I would like to see the Fed embark on QE3, but that is unlikely to happen.
What QE2 did was prevent deflation. 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 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 will 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 will have need of fewer employees. The resulting layoffs will result in still less aggregate demand. Lather, Rinse, Repeat.
Housing Keeping Core CPI Down
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 Case-Schiller. 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 24.91% of the CPI, or more than food and energy combined.
Regular rent, paid by tenants to landlords makes up another 5.93% of the overall CPI. The two rent measures tend to move closely together and combined make up 30.8% 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, 39.9%. Regular rent rose 0.1% in each ot the last three months, after three months in a row of rising by 0.2%. Over the last year it is up just 1.3%.
OER was up just 0.1% for the seventh month in a row. Year over year, OER — by far the most important single part of the CPI — is up just 0.9%.
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.
In a Sweet Spot
The Fed appears to have taken the treat of outright deflation off of the table, but I see little danger of runaway inflation. We seem to be in a bit of a sweet spot. The threat of deflation is gone. The markets are not anticipating a return to high inflation. If they were, they sure would not be willing to lend to the government for 10 years at only 3.20%. A return of under 3.2% per year is not very enticing for locking up your money for ten years.
Bond investors have to be concerned with headline inflation, not core inflation. 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 less than 1% per year.
At the first hint that inflation is picking up, bond yields can be expected to head much higher. 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. By the way, a good way to bet on T-note yields rising is the Short Treasury ETF (TBT).
Where Inflation Does Exist
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 0.5% in April, matching March’s rise, after a 0.7% increase in February. Year over year they were up 3.1%.
While Health care inflation continues to run hotter than the economy as a whole, it is also down significantly from historical levels. Part of the reason for that is probably the increasing substitution of generic drugs for name-brand prescriptions. For drugs that 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 now have to face the free market.
Medical Services prices (i.e. a visit to the hospital) rose just 0.3%, up from a 0.1% increase in March, but lower than the 0.4% rise in February. Year over year, medical service prices are up 2.8%.
(So tell me, how does the current rate of medical inflation justify the double-digit increases we are seeing in health insurance premiums? They don’t, but insurance companies still have very concentrated market positions in many states, and the effects of the Health care reform will not really kick in until 2014.)
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 next graph shows that health care inflation for both commodities and services is down substantially from a few years ago, but still generally runs much higher than overall inflation. That is at the very core of the long-run budget deficit problem.
HMO Margins Expanding
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 (UNH). 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).
Fairly Solid Overall
Overall this was a fairly solid — but not great — report. The headline number was a tick lower than expectations and core numbers came in one tick higher than expected.
Even the headline number is not at a particularly dangerous level. If we had 0.4% inflation each month for a year, then inflation would run at 4.9%. Uncomfortable, yes, but a level that we have survived very well in the past. Not great for anyone holding a long term bond, but far from the Weimar Republic.
Core inflation, though, inflation remains very tame — a 0.2% monthly rate, if maintained for a full year, would translate into inflation of 2.4%, a bit above the current rate, but very much in line with its historical pace over the last few decades.
There are other ways of measuring the underlying rate of inflation. Two that the Cleveland Fed have been tracking are the median CPI and a trimmed mean CPI (which cuts off the most extreme increases and decreases in prices). The story they tell is very similar to what the conventional core CPI is saying, as can be seen in the graph below.
Yes, things have ticked up off the bottom on all three measures, but remain extremely low by any historical perspective. If inflation is a real problem now, then it must have been a catastrophe under Clinton and both Bush presidencies.
QE2 is bullish for stocks and commodities, a mixed bag for bonds (the additional buying pressure from the Fed would reduce yields, but to the extent that QE2 raises expectations for inflation going forward, long-term yields would tend to rise). It seems as if the latter effect has won out in the short term.
QE2 should bearish for the dollar (and thus bullish for other currencies) but so far the effect seems to have been offset 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.
While monetary easing is probably less effective at this point than fiscal stimulus would be in bringing down inflation, we clearly are not about to get any fiscal stimulus. It is not the best medicine possible, but it is the only medicine available in the current political climate, and now even it is about to end and does not seem likely to be renewed.
Austerity or More Stimulus?
What the economy really needs is more fiscal stimulus, yet all the talk is about austerity. Take a look at this final graph. It compares the history of unemployment to that of core inflation. How could anyone glance at that graph and say: “The thing we really have to worry about here is inflation — we can just ignore the unemployment situation”?
Over the long term, higher inflation is not conducive to low unemployment. For right now, any steps taken to fight inflation are likely to slow the pace of the recovery, and thus keep more people unemployed longer. The pace of layoffs is way down, so the vast majority of people who still have their jobs do not fear losing them as much as they did a few years ago.
The problem is the pace of hiring is absolutely anemic, so those who are out of work are having no luck at all in finding new employment. As a country, it looks like we are just writing off those fellow citizens through extremely short-sighted attempts to cut spending now — and hard.
Further, the spending cuts are aimed directly at the people we seem to be writing off. Since the spending cuts will slow the economy and thus lower tax revenues, the spending cuts are not even likely to be effective in terms of making a serious dent in the budget deficit.
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