Inflation up Close
02/29/08
Wall Street was hit with more bad news this past week. The list is long: the durable goods report was weaker than expected, new home sales reached another low not seen since 1995, Fannie Mae and AIG both reported dismal quarters, 2.2% of all prime mortgages are at least 60 days late (up from 1.5% last year) and more than 20% of all sub-prime mortgages are 60 days late, which is probably the reason that consumer confidence dropped to new lows for the cycle. This sentence was of average length and I barely managed to pack in half of last week's abysmal economic news. I will spare you the rest; you can read it in every newspaper. Every market participant is crying "uncle" now, "Uncle Ben" that is. The hope is that his cavallery of the Federal Reserve will rescue Wall Street from itself again by continuing to lower interest rates aggressively. This course of action seems obvious and prudent, given the Fed's dual mandate of ensuring full employment while maintaining price stability. The problem is that price stability seems to be slipping away from them. The producer price index (PPI) for the month of January was announced on Tuesday, and just like the consumer price index (CPI) the week before, came in hotter than expected. Clearly, inflation continues to surprise to the upside, which is surprising in itself, since the popular inflation indices such as the CRB index are making new highs almost daily. Nevertheless, Wall Street seems to have calculated inflation too conservatively. So let us explore the concept of inflation before we judge those Wall Street types too harshly: The Cleveland Fed's website, which is very educational and deals with the topic exhaustively, says: "Inflation, a rise in the general level of prices caused by excessive money creation, is not an easy thing to measure. Prices for individual items fluctuate constantly for reasons that have nothing to do with inflation, and an accurate measure of inflation must distinguish between these relative price movements and inflation."
The CPI measures the average price of a fixed set (or basket) of goods and services. The basket of goods is intended to reflect all of the items a typical family buys to achieve some minimum standard of living in some base period (currently, 1982-1984). The basket is adjusted every ten years or so. Another commonly used measure of "true inflation" is the CPI excluding food and energy or "core CPI". This measure of core inflation systematically excludes food and energy prices because, historically, they have been highly volatile. More specifically, food and energy prices are widely thought to be subject to large changes that often fail to persist and frequently represent relative price changes. In many instances, large movements in food and energy prices arise because of supply disruptions such as drought or OPEC-led cutbacks in production. I have heard many complaints about this concept of measuring inflation by excluding the most inflationary components. God knows, I have complaint about it myself often enough. Nevertheless, the two charts above show you that inflation will show itself, whether you include food and energy or not. You can see that the CPI topped out in April 1980 at 14.59%. The core-CPI topped out in June 1980 at 13.60%. Exactly 1% and two months difference. That same difference might even hold true today. As you can see, the CPI has reached 4.6% in January this year. I would not be surprised, if the core-CPI, which stood for the month of January at 2.46%, would get to 3.5% in March of this year. That would definitely get Bernanke's attention. A core-CPI that is 1.5% higher than the upper end of the Federal Reserve's expressed comfort-zone would also get the market's attention. It is, of course, always possible that the basket which the Bureau of Labor Statistics measures is not reflective of what is happening in the real world. There are many other ways to measure inflation, though. Let us look at two more:
The first chart above shows you the Personal Consumption Expenditures Chain-Type Price Index (PCE Index) in red and the "Core-PCE-Index" in blue. The red line reached a high of 11.48 % in March of 1980 whereas the blue line (the "core-PCE") reached its peak at 9.37% 9 months later in January 1981. The difference here amounts to 1.11% and 9 months. Both PCE-indices had reached that same general level of roughly 10% and 12% some 6 years earlier already. While the CPI and core-CPI went to higher highs in 1980, the PCE did not. Neither did the implicit price deflator (second chart above), which is released as part of the quarterly GDP report. The GDP deflator is a measure of the change in prices of all new, domestically produced, final goods and services in an economy. It seems clear that each index has advantages as well as disadvantages and that each attempt to capture "the real world" behavior of prices and inflation in a model must be doomed, no matter how clever the approach may be. One thing seems to become clear, the longer one studies these approaches; they may differ as far as the absolute percentage of broad price increases is concerned, but they always get the direction right. The absolute levels reached by each index may differ somewhat, but they all peaked and reversed course within 9 months. The two CPI indices reached their first high in 1974 at 12% and surpassed those highs 6 years later. They peaked in 1980 around 14%. The two PCE indices reached 10% (12%) in 1974 (during the "first oil crisis") and never made higher highs in 1980 during the "second oil crisis"). The GDP-deflator made a lower high at 11% in 1980 versus the first high at 12% in 1974. The absolute price increase percentage ranged from 10% to 14% between the four indices, but they all reached their respective peaks within 9 months. The indices above emphasize and de-emphasize to a varying degree food and energy costs, but even if we include all raw material prices, the timing of the inflation peaks remains the same. The Producer price Index (PPI) which is not shown here reached it's high of 19.49% in 1974 and made a second lower high of 14.71% in 1980. The "core-PPI" reached 15% in Feb 1975 and 11% in Aug 1980. All indices are constructed differently and all domestic inflation measures have been rising lately, that seems clear. The question remains, if they will continue to rise in the future. They may, for a couple of months at least. The U.S. economy however is slowing down significantly and drags the rest of the world down. If one quarter of the world economy slows down dramatically, it will affect the rest of the world, decoupling or not. Europe will be next. The worldwide de-leveraging continues and will exercise its deflationary force. This bodes well for diminishing inflationary pressures in the future. One reason why I feel optimistic about diminishing inflationary pressures in the future (and perhaps rising deflationary pressures in the future) is not entirely scientific but resides mostly in my gut. Look at the following chart, which I constructed based on Helene Meisler's idea last week:
One chart represents the NASDAQ from 01/01/1999 to 03/10/2000 and the other one represents the CRB Index from 01/01/2007 to 02/29/2008. Can you tell which was then and which is now? Does it really matter? It sure feels like a bubble, does it not? Keep in mind that the NASDAQ traded below 2,000 within a year after reaching its peak at 5,000. I know that this is different. I also know that it was different then. Just sayin'.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.