Core CPI Still Tame - Analyst Blog

The

rose by 0.5% in February, up from a 0.4% increase in both January and December. While that sounds bad, year over year it is up just 2.1%. Looking a little bit deeper, the problem is mostly with energy, and to a lesser extent, food prices.

Energy prices surged 3.4% on top of a 2.1% increase in January and a 4.0% jump in December. Overall, energy prices are up 11.0% year over year. Actually the increase is even narrower than that, as energy commodities, such as gasoline and heating oil were up 4.8% after an increase of 4.0% in January and a 6.4% surge in December.

Year over year, energy commodity prices are up 19.3%. 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 1.1% for the month, but have generally been much more tame. In January they were down by 0.6%, but were up by 0.6% in December. Year over year, energy services prices are up just 0.2%.

In other words, the pain is at the pump, not in the plug. It also suggests that Electric Utilities are not the place to put your money right now (also confirmed by the big back-to-back drops in utility capacity utilization, see:

).

Food prices, which had been relatively well behaved, are starting to act up as well, rising 0.6%. That is after a 0.5% rise in January, but in December they were up just 0.1%. Year over year, food prices are up 2.3%.

However, food prices at the grocery store are rising faster than restaurant prices. Grocery store inflation was 0.8% in February, after being up 0.7% in January. They rose just 0.2% in both December and November. Year over year “food at home” inflation is 2.8%. That is hardly Zimbabwe, but it is higher than the rest of the economy, and if the January 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. So far they have had relatively little impact on consumers shopping at

(

), 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.

Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up 0.2%, matching the January increase and up from back-to-back increases of 0.1% in December and  November -- and after three straight months of being unchanged. Year over year, core prices are up 1.1%.

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.

This report is a vindication of the Fed decision to undertake another round of quantitative easing. The danger of QE2 is that it could set off a round of inflation, many critics say hyperinflation. That, however, is not the danger the economy faces, deflation is. People hyperventilating about inflation need to get a bit of historical perspective.

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 would 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.

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 February, after three month in a row of rising by 0.2%. Over the last year it is up just 1.1%.

OER was up just 0.1% for the fifth month in a row. Year over year, OER, by far the most important single part of the CPI is up just 0.6%.

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.

The Fed appears to have taken the threat of outright deflation off of the table, but I see little danger of runaway inflation. Yes the PPI, which came out yesterday, was a bit on the hot side, rising 1.6% for the month and up 5.6% year over year. Core prices are still well contained even at the Wholesale level, rising just 0.2%, down from a 0.5% increase in January. Core PPI inflation is only running at 1.8%, and that is a far cry from Zimbabwe.

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 3.26%. Yes rates are up sharply over the last three months of so, but that appears to be from the threat of deflation receding, and from a greater demand for funds as the economy improves, rather than from a fear of high inflation.

Even after the recent bounce, a return of under 3.3% per year is not very enticing for locking up your money for ten years. 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 almost nothing.

At the first hint that inflation is picking up, bond yields can be expected to head much higher. Even though I think that deflation is still a greater threat right now than a return to the high inflation of the 1970's, I do not think that the Fed will allow it to happen. QE2 is aimed directly at preventing that from occurring.

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. A good way to bet on T-note yields rising is the

(

).

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 0.7% in February on top of a 0.5% increase in January after rising 0.1% in December and 0.2% in November. Year over year they were up 2.7%.

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

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) and

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) 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 0.4%, but that is after they actually fell 0.1% in January. In December they were up 0.3% on top of an increase of just 0.2% in November. Year over year, medical service prices are up 3.0%.

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 they are far below the average rate of medical inflation in recent years (decades).

The differential between the increase in health insurance costs and actual medical inflation suggests that margins should increase significantly for the major HMOs like

(

). 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 next graph compares year-over-year health care inflation to total inflation since 1985.

Overall this was a fairly solid -- but not great -- report. Both the headline and core numbers came in one tick higher than expected, but 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. Core inflation remains very tame -- a 0.2% monthly rate if maintained for a full year would translate into inflation of 2.4%.

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 (once again

).

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 Reagan, Clinton and the Bushes.

The report does not totally put to bed the danger of deflation, but is pretty close to doing so. It certainly does not raise the specter of runaway inflation any time soon. It vindicates the Fed's decision to go ahead with QE2  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 later effect has won out in the short term).

QE2 should be 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(s). QE2 should end the risk of outright deflation and at the margin should help the overall economy. With the overall economy showing signs of better growth, the time-frame for the QE2 program might be stretched out a bit, with the $600 billion purchase of T-notes being finished in say September rather than by June, but I do think it will be completed.

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. 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.