The Consumer Price Index (CPI) rose by 0.5% in July, more than reversing a 0.2% decrease in June and up from its 0.2% rise in May. Year over year it is up 3.6%. It was well above the consensus expectation of a 0.2% increase.
Behind the Headlines
Looking a little bit deeper, the increase in headline inflation is mostly with energy, and to a lesser extent, food prices. Energy prices rose 2.8%. That is after a drop of 4.4% in June and a decline of 1.0% in May. Those declines were, however, after a long string of big increases. Overall energy prices are up 19.0% year over year.
Actually, the movement is even narrower than that, as energy commodities such as gasoline and heating oil were up 4.3% after being down 6.3% in June and off 1.9% in May. Year over year, energy commodity prices are up 33.3%. The relative pricing strength in energy commodities year over year 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, are much better contained, rising 0.4% in July after declining 1.1% in June and rising 0.6% in May. Year over year energy services prices are up just 0.9%. In other words, the pain has been at the pump, not in the plug. While oil prices have been very volatile, they have fallen sharply during the recent market turmoil, so we will probably see energy commodity prices fall in August.
Food Price Inflation
Food prices have been a bit more problematic than overall inflation, but nothing like energy commodities. They rose 0.4% in July, up from a rise of 0.2% in June and matching May’s 0.4% increase. Year over year food prices are up 4.2%. However, year over year 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 0.6%, up from a 0.2% increase in June and a 0.5% rise in May. Year over year “food at home” inflation is 5.3%. That is hardly Zimbabwe, but it is higher than the rest of the economy. That sort of pace would take a serious bite out of consumers’ wallets.
Due to poor harvests in several important areas of the world last year, most notably due to droughts in Russia, and floods in Pakistan and Australia, agricultural commodity prices have been rising sharply. Given the floods in the Midwest earlier in the year, and now a severe drought in the South, I suspect we are going to see a lousy harvest this year, and that will probably lead to more food price inflation in the fall.
In the short-term, though, meat prices may fall as ranchers send cattle to slaughter since they can’t graze them on parched land. Enjoy the cheap meat for the grill this summer, because you will more than pay for it later on.
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.
Core Inflation Rising Moderately
Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up 0.2%, down from a 0.3% increase in both June and May. Year over year core prices are up 1.8%. The recent rise in core prices is worth watching, and is a reason for concern, but not panic. If the last three months are annualized, core inflation is running at 3.2%.
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 22.8% 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 coming off a near 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 record low level of 0.6% was set in October, and records go back to 1957.
The Fed’s Job Gets Trickier
The rise in core inflation makes life a bit more difficult for the Fed. It has a dual mandate to both control inflation and to promote full employment. It is still doing a good job on the inflation front (although performance is slipping). But at 9.1%, the unemployment situation is anything but satisfactory. QE2 is over, and while the Fed has left the door open to QE3, it is only open a crack, and this report shuts the door a bit further.
What QE2 did was that it prevented 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 with deflation. This wouldl 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.
Deflation is no longer an immediate threat, and it would probably have to reemerge as a credible one for the Fed to do another round of quantitative easing, in addition to having a weak employment picture.
The Most Important Figure in the CPI
The key reason why the core CPI has been so low of late is the cost of shelter, but that is starting to change. 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).
OER 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 0.3%, up from 0.2% in each of the previous two months. Prior to that, it had been consistently either unchanged or up 0.1%. Over the last year it is up 1.6%. This year will probably see a record low for the number of new apartment units added to the nations housing stock, and rental vacancies have been falling.
OER was up 0.3%, accelerating from 0.2% in June and 0.1% in April (and in each of the eight months before April). Year over year, OER — by far the most important single part of the CPI — is up just 1.2%. The acceleration in OER inflation in the face of extremely low mortgage rates and falling home prices (seasonally adjusted) is problematic.
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 out right deflation off of the table, but I see little danger of run away inflation, even with this month’s uptick in headline prices. 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 less than 2.00%. A return of under 2.00% 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 are buying a certificate of confiscation of real purchasing power, not an investment.
Deflation is the only scenario under which the purchase of long-term treasuries makes sense at these levels, and the Fed has made clear that it is not going to let that happen (nor should it). To buy a long-term T-note, you’d have to be rooting for breadlines and Hoovervilles.
Where Inflation Exists
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, and are getting more so. Medical commodity prices (i.e. drugs) rose 0.3% in July, but only after they fell 0.1% in June, after being unchanged in May. Year over year they were up 3.2%.
In other words, medical commodity prices have been running below that of the overall economy for the last year, which is very unusual. They are still running hotter than core inflation, though. 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 just 0.3%, for the fourth month in a row. Year over year, medical service prices are also up 3.2%. The slowdown in health care inflation could be very significant if it can be sustained.
The central issue behind the unsustainable long-term federal deficit projections is rising health care costs. It is not that Medicare/Medicaid/V.A health care are all that inefficient, they are not. It is that health care costs have been spiraling out of control for decades now, and health care costs thus are absorbing an ever increasing share of the economy.
Since the government pays about half of all health care expenses, it is inevitably impacted. The next graph shows that HC inflation, for both commodities and services is down substantially from a few years ago, and has finally broken below overall inflation (but still running hotter than core inflation). That is at the very core of the long-run budget deficit problem.
The differential between the increase in health insurance costs and actual medical inflation suggests that margins should increase significantly for the major HMO’s 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). The graph above compares year-over-year health care inflation to total inflation since 1980.
We need to get health care costs under control, not just shift who has to pay for them to those who are least able to do so, as has been suggested in Congress. While it is way too early to declare victory, the recent health care inflation data is very encouraging, and indicates to me that the ACA is already having a positive effect, although there could be other factors involved, and the most important provisions of it don’t kick in until 2014.
New Car Prices
New car prices were unchanged in July after being up 0.6% in June on top of a 1.1% rise in May and are up 4.0% year over year. The decline might indicate an easing of the supply chain disruptions due to the Japan disaster. However, used car prices are rising even faster, up 0.7% in July after rising 1.6% in June and 1.1% in May. Year over year they are up 5.3%, but if you annualize the last three months they are rising at 14.0%, while new car prices are rising at 7.0%.
The faster rise in used car prices has been persistent over the last two years. Obviously there has to be some limit to that — otherwise we would get to the point where a used car costs more than an equivalent new car.
The rapid rise in used car prices might simply be a reflection of the weak economy. People who can’t afford a new car but still need to get around are opting for buying a used car. A classic “inferior good” situation. Together, new and used cars have a bigger weight in the CPI than do energy commodities.
Disappointing, Not a Disaster
Overall this was a disappointing, but not disastrous, report. The headline number was much higher than expectations but the core numbers came in as expected, and at a still well-contained level. The core is what you need to watch if you are trying to figure out what the Fed is going to do. The reason food and energy prices are excluded is that they are very volatile and as such current levels are not very good predictors of future rates of inflation.
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, it must have been a catastrophe under Clinton and both Bushes.
Headline inflation was much worse than expected, but that was all due to gasoline prices, and the price of oil has recently come down. Thus it is reasonable to expect that in August, headline inflation will run below that of core inflation. The level is higher than the Fed would like it to be, but it is not awful.
Core inflation is up off the record lows of last fall, but still at a historically low level. This report makes QE3, already a low probability and even lower one. I would like to see more stimulus in the economy given how far we are below potential, but more monetary stimulus would not be my first choice.
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”? Yes, unemployment has started to decline, and core CPI is up a little bit, but by any historical standard inflation is extremely low and unemployment is still very high.
There is a trade-off in policy choices between fighting inflation and fighting unemployment, at least in the short to medium term. 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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