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The Inflation Trend Is Not Yet “Tamed”


Inflation Unlikely to Be a Cause for Concern,”  expressed the Wall Street Journal today. “The cost of oil, metals, and grains would have to jump another 20% to 30% in coming months [my note: actually, just oil] to trigger a repeat run-up in consumer prices next year. Absent that, headline inflation rates are poised to weaken.”

U.S. Consumer Prices Stagnate as Fuel Costs Show Inflation Tamed”  said the headline on Bloomberg.

Why the sudden emphasis on headline inflation, now that it’s converging back to core? Why are pundits abruptly myopically focused on fuel, which is 9.1% of the consumption basket (although a good part of its volatility)? I would suggest that this spin on the headline derives from the fact that economic prognosticators have been saying for some time that the slow global growth will keep inflation contained, and so they are beginning to obsess about the parts of the price index that appear contained even if they are not the important parts of the index.

Meanwhile, core inflation rose +0.173%, bumping the year/year rise in core inflation to 2.153%. Both were above expectations. Look at the chart of core inflation, below, and objectively try and decide if that looks like a “tamed” inflation trend. To me, it looks like a trending trend.

Tame? Only if you're already assuming the trend stops.

The last time year/year core inflation was 2.2% was in October 2008. It took exactly 2 years to decelerate to a low of 0.6% in October 2010. It took 13 months to return to the level. And as the chart makes clear, it has been a straight shot. Year-on-year core inflation has not fallen in a single month since October 2008.

It isn’t as if this rise is being caused by wages, or by medical care, or by fuel. While the second story below takes pains to blame it on “higher medical care and clothing costs”, in fact most of the basket is accelerating. The table below shows the eight major subgroups.

Weights y/y change prev y/y change 1y ago y/y change
 All items

100.0%

3.394%

3.525%

1.143%

  Food and beverages

14.8%

4.373%

4.470%

1.496%

  Housing

41.5%

1.918%

1.869%

0.010%

  Apparel

3.6%

4.763%

4.194%

-0.790%

  Transportation

17.3%

8.024%

9.185%

3.750%

  Medical care

6.6%

3.370%

3.116%

3.184%

  Recreation

6.3%

0.348%

0.253%

-0.862%

  Education and communication

6.4%

1.418%

1.371%

1.590%

  Other goods and services

3.5%

1.858%

1.660%

1.840%

 

From last month, acceleration in the year-on-year rate happened in Housing, Apparel, Medical Care, Recreation, Education & Communication, and Other, totaling 67.9% of the basket, while Food & Beverages and Transportation (mostly due to energy), 32.1% of the basket combined, decelerated. And, from 6 months ago (shown below), every major group has accelerated its year-on-year trend except Transportation (again, because of energy prices) even though the headline inflation rate itself has fallen.

Weights y/y change 6m ago y/y chg
 All items

100.0%

3.394%

3.569%

  Food and beverages

14.8%

4.373%

3.363%

  Housing

41.5%

1.918%

1.159%

  Apparel

3.6%

4.763%

1.045%

  Transportation

17.3%

8.024%

13.098%

  Medical care

6.6%

3.370%

2.995%

  Recreation

6.3%

0.348%

-0.022%

  Education and communication

6.4%

1.418%

1.029%

  Other goods and services

3.5%

1.858%

1.517%

This bears repeating. There has been a 5% fall in the year-on-year rate of inflation in 17.3% of the basket. That causes an 0.88% drag on the headline number. But the headline number only dropped from 3.569% to 3.394%, because every other major group accelerated.

You can call that “tamed” if you want to. I will say that it is surprising our models, which a year ago only expected core inflation to be in the 1.6%-1.8% at year-end 2011. Housing inflation in particular has remained surprisingly high despite inventories which should be pressuring rents and home prices. And yet, prices are rising. There is just no sign of deceleration in core inflation at this point, although core inflation ex-housing rose only to 2.37% and will probably only be around 2.6% by year-end, a trifle lower than we were expecting two months ago.

This is not a growth story. While economic data on Thursday was better-than-expected, with another eyebrow-raising decline in Initial Claims and better-than-expected readings from Empire Manufacturing and Philly Fed, recovery today (such as it is) doesn’t affect inflation today. Inflation, if it responds to growth at all, is supposed to respond with a lag. So that’s not what is happening here.

The best candidate continues to be money and lending. M2 on Thursday night bounded ahead again, pushing the 52-week change up to +9.6%, and the 52-week rise in Commercial Bank Credit reached 2.5% for the first time since November 2008. The chart below shows both the rise in Commercial Bank Credit and the contemporaneous rise in CPI for the last few years. CPI seems to respond to changes in credit with a 6-12-month lag.

Commercial Bank Credit vs Core CPI - related, or at least both related to a third thing.

Well, I am not saying these things are necessarily causally related because if we trace this back to the early 1980s the fit is less persuasive, but I suspect there is a causal link which becomes more apparent when other factors are muted. It certainly fits with theory that money and lending should impact prices.

Assessing all of the data, I cannot see how a neutral observer can look at current price trends as being “tame” or “stagnated,” and I can easily see how inflation might become a cause for concern…even if it isn’t already.

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  1. December 16, 2011 at 6:45 pm

    Hey, Mike, good column. For us non-inflation gurus, can you explain again the bit about how the housing component is calculated? My observation here is that rents are actually rising, despite–or rather, because of–the continued weakness in homes and tightness of mortgage credit. In other words, rents are pressured higher by the substitution effect from not being able to buy. My own anecdotal story is this: I am a partner in a venture which completed an apartment building project here in Madison in June. We put out the building for pre-lease in March, it was oversubscribed and completely leased out by mid-April at rents 5-7% higher than the upper end of our projections.

    Is the housing component calculation perversely impacted by this substition effect?

    • December 17, 2011 at 12:42 am

      Well, not perversely!

      When you buy a house, you get two things. You get an investment, and you get a place to live. We don’t want to include the behavior of the investment in the CPI, for the same reason we don’t include, say, the stock market. But the investment and the stream of services the house provides are intertwined. How can we evaluate the value of what you consume in owning a house, as distinct from the value of the investment?

      The obvious answer, although this wasn’t the way they used to do it (and it drives Shadowstats mad that they actually improved the method), is to try and observe a market where people buy shelter directly, with no investment attached. In other words, rentals. The exact way they do this is elaborate and there’s a lengthy exposition on the BLS website, but I don’t think that’s your question.

      The fact that it works pretty well is obvious when you look at what happened to housing inflation during the housing bubble. It rose, but not very much (especially when compared to the spike in housing prices), and then declined, but not very much, when the bubble burst. Which makes perfect sense: the bubble was in the investment value of the home, not the place-to-live-in value.

      Early in the crisis there were economists who said that rents would shoot higher because home prices were collapsing, which was complete economic gibberish because the price of a substitute should move in the same direction. But you’re talking about a different phenomenon, not “substitution” in an economic sense. You’re talking about the markets CEASING to be substitutes, and so they’re subject to different supply and demand constraints. In the rental market, there’s more demand relative to supply because the lack of mortgage availability blocks renters from participating in a market (the owner market) that used to be a substitute. That’s a deep insight, and very clever. And I think there’s probably a paper in there somewhere!

  2. gary leibowitz
    December 16, 2011 at 6:51 pm

    Beyond tame. Deflation will hit with a vengence next year. I am amzed that for the past 3 years we have had a world wide credit crunch and mountains of unresiolved debt the talk is still on inflation.

    Commodity surge comes in 2 flavors. One, money chasing commodities since real estate, equities, treasuries are not attractive. Two, third world entry into western style capitalist growth.

    With the EU crisis just getting started, and China having recessionary trends of late, there is no way inflation gets going. in fact the EU mess, combined with China slowdown will accelerate deflation trends.

    • December 17, 2011 at 12:52 am

      Funny, we’ve had the worst world-wide depression in 80 years and core prices have never fallen…you don’t think maybe there’s something wrong with the notion that slow growth causes disinflation or deflation? I think you really ought to look at the second chart of the comment I had last month, http://mikeashton.wordpress.com/2011/11/09/oh-that-italy/ .

      Now, if you’re arguing that money velocity will suddenly collapse finally next year and we will get deflation, then your argument is consistent, but I hope your prognostication is wrong. I don’t see any reason to think velocity will suddenly plunge; it fell in 2008 and 2009, went flat, and then fell some more this year, but the combined contraction in velocity was no more than the contraction seen in the last recession (and the 2011 drop may well be an artifact of lag although we won’t know for a while).

      So, I disagree with your conclusions. The signals are all pretty much unambiguous at the moment, and while they may suddenly reverse and core inflation start to fall, there’s no sign of it yet (and the current rise is entirely consistent with models that predicted it more than a year ago).

  3. Jim H.
    December 17, 2011 at 4:22 pm

    ‘There has been a 5% fall in the year-on-year rate of inflation in 17.3% of the basket … every other major group accelerated.’

    In TA terms, the core CPI index components are sporting a strong 7:1 advance-decline ratio — a bullish sign for trend continuation, according to the grizzled old chart hounds.

    Paul Kasriel at Northern Trust has been pounding the table for months about the importance of getting commercial bank credit growing again. Given its healthy rate of change shown in your chart, Kasriel probably will take the other side of the trade from ECRI’s equally table-thumping recession call.

    You note in comment #2 that investments aren’t included in CPI. Yet in those outlier households that actually save, investments are a small but significant portion of their budgets. While it wouldn’t be an appropriate cost-of-living measure for seniors who are dissavers, I’d be inclined to experiment with including a small weighting (say 5%) of capital assets in my version of CPI, to account for the relative valuation of the three major investment assets (stocks, fixed income and property).

    In the 21st century, we’ve seen stocks (2000), residential real estate (2006) and bonds (2011) reach quite extreme (thus “expensive”) valuations. These capital asset phenomena probably are driven by changes in credit too, like the price of other goods and services.

    It may sound pointless, but it’s my attempt to reconcile the seeming mirror image between decades of “bad inflation” such as the Seventies (when goods prices skyrocket, while stocks and bonds stagnate), versus decades of “good inflation” such as the Nineties (when asset prices run away while commodities stagnate). If both capital assets and goods & services are included at proper weights, we might find that it’s all the same inflationary process, but manifested in alternating ways.

    • December 17, 2011 at 5:20 pm

      It’s a good point, but here’s one reason this is difficult…it’s a ‘stock’ versus ‘flow’ problem. Falling asset prices are GREAT for a young saver because they are buying at lower prices, but bad for an older saver because their stock of savings is declining. So should it be reported as an increase in standard of living (because for a younger saver, it is) or as a decrease in standard of living (because for an older saver, it is)?

      The same problem doesn’t exist as starkly with, say, fresh vegetables because while some people benefit (farmers!) more people are consumers of vegetables than are producers of vegetables. You know?

      I think that we can fairly represent asset prices separately from consumer prices and then add them together in different proportions for different age groups…how about that?

  4. Jim H.
    December 17, 2011 at 4:41 pm

    Just found Kasriel’s latest update: “The previous headwind of contracting U.S. bank credit has now shifted into a tailwind.”

    http://static.safehaven.com/pdfs/kasriel_2011_12_16.pdf

    So Kasriel thinks the U.S. will avoid recession, while Europe will experience a mild one. But he hews to the conventional wisdom (p. 23) that slowing global growth will weaken commodity prices and CPI inflation.

    • December 17, 2011 at 5:21 pm

      Funny we disagree on both parts! Although I am increasingly coming to his view that – absent further calamity in Europe – the US will not have a recession. Problem is that I think the chances of further calamity in Europe are about 90%! :-)

  1. January 3, 2012 at 6:26 pm
  2. January 18, 2012 at 10:07 pm
  3. January 21, 2012 at 9:53 pm

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