Deconstructing Inflation

As the page turns to a new year and a new President, bond investors fear the return of inflation. Tight labor markets, expected fiscal stimulus, deficits, the pullback of monetary stimulus, and reduction by a primary holder of US Treasuries are bringing higher inflation expectations. After a thirty-five-year run for bonds, the cycle certainly seems long in the tooth. Nonetheless, proper positioning for higher inflation requires understanding the drivers of inflation; no matter their uncertainty. As with any strategy, the inability to identify critical factors will deliver improper focus and a response unsuited for the environment.

Unpacking the basket. Inflation is frequently measured by changes in the Consumer Price Index (CPI) that captures the cost of a basket of goods and services for the typical urban consumer. The major components of the index consist of roughly equal weights in services, shelter, and commodities, while durable goods are only one-third of the other components. While these weights change over time, it is evident that changes in the current index result from changes in wages, housing prices, and consumable goods (food and energy), with imported goods having little impact, for now.

Services are the many things that are provided for us by other people and include medical care, recreation, education, communication, and transportation. While the shelter component is self-explanatory, commodities include food and beverages, utilities, and gasoline. The last segment, durable goods, are all those items that last for an extended amount of time and include television, computers, cars, and household appliances. One of the distinguishing features of the four groups is that services and shelter are non-tradable local goods, while commodities and non-durable goods are global traded goods and standardized across the world.

Hedonistic Living. The rather opaque construction of the CPI index was devised by the laborious mind of an economist to measure the change in the cost of living and may have debatable merits as a measurement tool. Some suggested arguments for improvement, other measurement techniques proposed, and economy-wide indices used, the CPI remains arguably the most reliable. Regardless of the alternatives, the hedonistic adjustments undertaken to adjust for changes in the quality of the products and services consumed is the most impactful and most difficult to capture.

There are benefits of the hedonistic adjustments that account for quality changes in the basket; however, this action hides the natural tendency for business to reduce prices through the miracle of progress and its derivative efficiency. Since the impact of productivity is removed from the index to maintain comparable "baskets" through time, the natural tendency for the price of goods and services to fall is unseen in the index. As we enjoy the merits of computers exponentially stronger than a generation ago, we must reconcile that what once filled a room and was the extravagance only a government could afford, now rests in the hand of the average juvenile, at a price of pennies a day. This impact most likely overstates inflation. Progress yes, deflation no.

Pricing Efficiency. As the microeconomist extol, the price of a product is where supply and demand conspire to meet in full view of the market participants. Some markets are not transparent, and asymmetric information can distort the price discovery process. Many a government official is assigned to oversee markets, and in some other benevolent cases, they are policed by themselves, where, of course, no conflict of interest can occur. The degree of pricing efficiency helps determine the prospect of future inflation.

Commoditized goods and services make up the bulk of the CPI. Commodities that are traded globally in liquid markets tend to reflect fair prices. Fruit on the shelves during the winter in Chicago reflect this outcome. While linking commodities prices to the US dollar is mostly neutral for the US consumer, there are times when commodity prices move faster than currency markets and create an implicit tax on consumption.

A higher price for commodities sent the US dollar down, which should have slowed imports; however, this was not the case. The Chinese fixed exchange rate with the US dollar permitted trade to expand as there was not a loss in purchasing power. In fact, durable goods, particularly globally traded goods that include electronics, continued their price declines. So, while consumers faced increased costs of commodities, they gained on lower prices for durable goods.

Sticky Prices. The real estate market is notoriously inefficient at the individual level; however, there may be some efficiency depending upon how it is measured. Interestingly, when national house prices crashed, there was not a corresponding movement in the CPI shelter price index. This inconsistent outcome most likely reflects the questionable methodology that asks people what they might charge for rent, rather than what rent is possible. Also, housing affordability was somewhat mitigated by lower interest rates. The result was sticky housing costs that neither climbed, nor fell as much as housing prices.

Services, principally the wage cost of labor, also saw sticky prices that tend not to see declines, even though demand can dramatically vary. While benefit costs can change and the workweek extend, the overall cost is most dependent upon wages. With the continual fall of unionization, bargaining power has declined, and wage pressure decreased. When adding the outsourcing of jobs to the dynamic, the ability of wages to accelerate seems limited.

Strategy Risk. With global growth slowing a catalyst for an increase in commodity prices seems low, regardless of what some cartels try to achieve. Further, with the Chinese Yuan freely floating, the major distortion on the commodity complex is mostly removed. The combination of lower commodity prices and freely traded Chinese Yuan has resulted in an appreciation of the US dollar in real terms that reduces commodity and import prices for the US consumer. Augmenting these trends is continued low prices in the cost of shipping. The combination of all that will lower inflation pressures; however, the greater threat to tradable goods is trade itself.

Housing prices have recovered in some cities, while in others they remain far away from their peak. The trend in home ownership has stabilized, employment to population continues to improve, and the prime age cohort for housing formation is now the largest. Disappointingly, the new household formation has plateaued at current levels, renting is expected to increase, and new house sales have returned to their long-term level. Since housing demand seems self-limiting and room for expansion in supply is plentiful, immediate inflation pressure is not evident; however, renters may not agree.

Services is the last hope for inflation expectations. There is no question that the unemployment rate is low and seemingly constrains labor supply. The labor force participation rate tells another story. When combined with the number of workers that are part-time, there are millions of workers that can support continued employment growth at the current rate at a couple of hundred thousand per month. The pressure on wages may come, however, in the absence of a commodity or currency shock, it will most likely be a slow process, like the past.

There is no debate that a low and stable rate of inflation is the wind for the sail of business investment and a boon to the economy. Variability of future price expectations is what creates unease for business and banks. Since no one knows whether the dollar will inflate with tax policy or deflate with restricted trade, attaching a premium seems the most likely course given this future uncertainty.