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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. Man