The markets were roiled this week by a hot inflation reading. The Consumer Price Index, or CPI, rose 0.8% in April compared to March, and the index was up 4.2% compared to April, 2020. If we exclude the volatile categories of food and energy, the index was up 0.9% sequentially and 3.0% on a year-over-year basis. These YOY readings are well above the Federal Reserve’s long-term target of about 2%. Still, the Fed continues to communicate that the high inflation readings will be transitory because they are being driven by base effects (unusually low inflation at the onset of COVID last year) and COVID-related supply-chain bottlenecks. The Fed also continues to remind us that the central bank’s shift to “average inflation targeting”, or AIT, means that inflation will be allowed to run above 2% for undefined periods of time to make up for extended periods of sub-2% inflation. Is the Fed right to ignore this burst of inflation and stick to its script?
Today I wanted to delve into the “base effects” concept a little more. One obvious way to eliminate the effects of low inflation readings in 2020 is to look at 2-year rates of inflation. In the chart below, you will see that annual rates of inflation were indeed much lower over the past two years than they were over the past year. However, it’s worth emphasizing that the two-year rates of inflation for both headline CPI and core CPI (excluding food and energy) were both at 2.2% – already ahead of the Fed’s target. So has the Fed started the AIT clock yet?
Although the Fed likes to exclude the impact of price changes for food and energy due to their inherent volatility, I wanted to take a closer look at these categories given their importance to working-class Americans. In the chart below you will see the extreme volatility in the one-year numbers. The huge spike in energy prices was indeed due to base effects as energy prices plummeted in the early months of 2020. If we look at the two-year compound annual growth rates, the increase in energy prices was a much more modest 1.5% annually. In this case I think we can safely assume the outsized increases in energy prices over the past year are not going to continue. However, the recent shutdown of the Colonial pipeline may lead to some near-term volatility.
Food prices, on the other hand, have been running significantly above overall inflation, on average, over the past two years. Food’s weighting in the CPI is about 14%, which is well above the weighting for energy (6%-7%) but likely well below the proportion of spending for working-class families. Can the Fed afford to simply ignore fairly consistent increases in food prices? It would seem to me that food prices would carry more weight in formulating monetary policy rather than less.
The next inflation category to examine is commodities, excluding food and energy. Together, these expenditures made up about 20% of total CPI as of April, 2020. In the table below, you will see that despite a large 4.4% increase in prices over the past year, the average increase over the past two years has been a relatively benign 1.7%. The standout among this group is clearly used cars and trucks, which had a 2.6% weighting in overall CPI and surged 21% over the past year. This unprecedented rise in used car prices contributed over 0.5% to the 4.2% increase in overall CPI over the past year (despite the small weighting). The surge in used auto prices is due to a number of factors, including auto manufacturer shutdowns due to COVID and semiconductor shortages, fears over taking public transportation, the stimulus checks, and super-low interest rates. If there is one component of CPI (other than energy) that almost certainly will be transitory, it’s used car prices.
The category of CPI that has me most worried is shelter. Shelter accounts for about a third of CPI but can account for 40% or more of spending for lower-income families. And though the cost of shelter appears to have moderated due to the effects of COVID, the two-year growth in prices is a little troubling. In addition, many economists believe that rising housing prices and inadequate housing supply will lead to outsized growth in shelter costs in the months and years ahead. Homebuilders have been beset with labor shortages and rising materials costs, all of which seem likely to put further upward pressure on housing prices (absent a spike in mortgage rates).
The costs of other services are rising rapidly as well, often due to pent-up demand associated with COVID. In the table below, you will see that price increases have been elevated for water, sewage & trash collection, household operations (domestic services, gardening and lawn care, moving, storage & freight expenses, repair of household items), medical care (includes health insurance), and other personal (haircuts, legal, funeral, laundry, dry cleaning, financial services, etc). Given the inability of many service industries to find qualified employees, is it likely that pricing pressures for these types of services will subside? Maybe. Prices for transportation services have also grown a lot over the past year, driven by big gains in the cost of vehicle rentals, vehicles repairs and insurance, and public transportation. It seems more likely than not these prices will continue rising as travel explodes following a year of staying home. There are puts and takes in the remaining services categories. But my overall point regarding services is that their costs will ultimately be determined by how successful companies are in attracting qualified employees at affordable wages. That’s not a foregone conclusion given ongoing concerns about COVID, a wave of early retirements, skills mismatches, and other factors inhibiting job growth.
The Fed’s assessment that the burst of inflation will be transitory strikes me as a very precise call on a very imprecise and unpredictable process. There are lots of different variables involved, most important of which is probably the size of the spending bill that the Biden administration is pushing through Congress. How can the Fed know pricing pressures will subside if it doesn’t know the outcome of that process? Would you be comfortable expressing such confidence if you were Chairman Powell? I certainly wouldn’t.
To me, this whole process is looking increasingly like a question of trade-offs. The Fed’s goal in keeping interest rates low is to return employment levels to pre-pandemic highs (there are still some 7.6 million fewer people working now as compared to February, 2020). But what happens if the Fed’s initiatives, designed to recover the lost jobs, result in much higher prices for everyone, including those still unemployed? Would that be considered a success? Moreover, shouldn’t the Fed be concerned that prices for non-discretionary budget items, like food, medical care, and shelter, appear to be growing at much higher rates than inflation overall?
In my estimation, the markets got out over their skis in giving the Fed the benefit of the doubt. We are pretty clearly not going to have a definitive answer to the inflation question for at least several months. To assume that all will go smoothly strikes me as foolhardy. Yet valuations for many segments of the market remain dependent on the goldilocks outcome. As investors, we must recognize that now is the time to separate the quality from the hype.