Inflation and the CPI

April 01, 2022
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Inflation and the CPI

Inflation seems to be in the news daily and on everyone’s mind–I just filled up my completely empty gas tank at a cost of $133.40! – inflation is on my mind as well. Below are some facts as to what goes into Consumer Price Index (CPI), and comments on what such higher levels of inflation could mean for the economy and markets. Warren Buffet famously said that “forecasts may tell you a great deal about forecaster, but they tell you nothing about the future.” While we are not trying to predict the future, below is our best thinking on how rising prices may impact the economy over the coming few years.

The CPI is supposed to be a relative “average” level of inflation that consumers are experiencing.

A savvy client once asked me, “Michael, how can I calculate my personal level of inflation?” Great question, hard answer. To the extent your consumption basket of goods and services matches relatively well with the chart above, then the Bureau of Labor Statistic’s averages, CPI, is very relevant for you. However, many people’s purchases are different, trending higher or lower than the 7.9% inflation reported over the past year. Let’s examine a few of the most relevant categories, and sort through the implications.

Shelter, representing one-third (1/3) of the CPI, is calculated after asking tens of thousand of people, “how much are you paying in rent”, if they are renters, or “how much would you rent this house for” if you are homeowners (the so-called “Owner’s Equivalent Rent”). In the pandemic, when rents were frozen, or in markets where rental increases are capped, this can be a lagging statistic. Also, many owners don’t appreciate the state of the rental market, e.g. what is a fair rental amount for their unfurnished house? Note, CPI is not measuring the cost of buying a new property (which we all know has increased dramatically), as that is much more of an investment function. CPI was constructed to approximate a basket of consumption goods and services, not the cost of a durable, long-life asset purchases like houses, or stocks and bonds. These calculation nuances lead many to think that CPI is dramatically undercounting housing costs. However, if you already own your home, and either have no mortgage or have a fixed-rate mortgage, is your personal cost to own a home (other than utilities, taxes, upkeep, etc.) really increasing in such a manner as someone now renting? (Especially if you refinanced in the last few years, potentially lowering your costs.) Our take, is that this cuts both ways, overstating for some and understating for others, but since nearly 66% of Americans own their own home, this component of CPI, while very real for those purchasing, is not a huge driver for many of our client’s personal rate of inflation.

Food is the next biggest expenditure that goes into CPI, both eating out and at home, totaling about 14% of typical expenditures. Food, especially meats, cheeses, specialty foods and dining out, has obviously seen tremendous cost increases, and our belief is that those increases are not likely going away anytime soon. The global pandemic and resulting supply chain disruptions, trade disputes, labor costs and now the war in Ukraine have all coalesced, driving up the cost of food. This is a particularly difficult issue for those nearer the bottom of the economic ladder who tend to spend a higher proportion of their income on food and transportation. The question is, will such cost increases continue for the next several years? People tend not to sit still for long periods of time under such strains of higher inflation. Substitution of products, cutting back purchases, even starting your own vegetable or herb garden, are typical responses witnessed in the past, and I see little reason to suspect “this time is different”. Ask yourself this question: Am I really going to walk down the street to Urban Plates restaurant if my Asian Chicken Salad and soda now costs $27? Not likely, if Trader Joe’s market is just down that same street and an alternative salad costs only $5.99. We have now seen nearly two years of labor force participation growth as the economy continues to heal from the 2020/21 pandemic shocks. Labor costs will not improve overnight, but they should gradually come into more balance, albeit at a (likely) higher hourly cost. We believe persistent inflation in this Food category is unlikely over the next 3-4 years, but maybe for the next year or so. 

Lastly, Transportation and Energy, which represents around 13% of direct outlays for consumers, are rising at the fastest annual clip in more than a generation. Used car prices are up 20-40% over the last few years, while new cars, if you are lucky enough to find one, are currently selling above the sticker price. Given the global supply chain problems, geopolitical struggles, the difficulty our Federal Government has sticking with a long-term energy policy, combined with an increasingly affiuent population that demands a myriad of energy-consuming goods and services at its fingertips, this is the sector we think may have longer-term upward pricing pressure. Today’s high-end electric car is not the same as your father’s V-8 powered Buick because it is not simply a replacement good at triple the cost (unlike other static goods—a loaf of bread, a gallon of gas, etc.). Today’s car is a vastly superior performance and safety machine, with lane-correcting technology, multiple airbags, backup cameras, GPS navigation, anti-lock brakes and internet connectivity, necessitating dozens of pricey semiconductors to power these new features. Given our long-standing car culture, the U.S. seems likely to rely on automobiles for the forseeable future.

Impacts of Higher Inflation

For business, higher inflation is experienced by rising costs of inputs such as raw materials, purchased products or other services, and labor costs. Inflation tends to create rising revenues for firms that can pass on such higher input costs to consumers by raising prices. But ultimately, inflation leads to consumer problems if inflation runs too high for too long, as consumers represent two-thirds (2/3) of all economic activity and will pare back their spending if expenses begin to exceed their budget or comfort level for too long. Furthermore, inflation tends to lead to higher interest rates, a natural “braking” effect on the economy, as businesses and consumers generally cut back on borrowing as costs increase. Higher interest rates depress the value of existing fixed rate bonds since newer bonds can be obtained with a higher rate of interest than previously issued bonds. Lastly, higher interest rates tend to dampen stock prices, as investors worry both about the typical slowdown in economic activity such higher rates may bring, and the simple fact that bonds now have a higher potential return and comparatively look more appealing than when rates were lower. 

Many commentators and economists, including one of my favorites, Brian Wesbury, have valid arguments that inflation is first and foremost a monetary problem, and that the printing of too much money and insertion of such money into the financial system by the Federal Reserve, is the root of inflation. We have seen this argument before, since we saw the Fed pump in huge amounts of liquidity in response to the Financial Crises of 2008-09; that was also supposed to lead to massive inflation, and it simply did not happen. This time around we have already had a year of rising prices, the Fed starting to raise rates, and soon the shrinking of its balance sheet. We believe the supply response, the continuing technology and productivity improvements, as well as a return to more traditional consumption patterns, will cause inflation to turn the corner soon and ebb lower over time. The Fed is called upon again, to engineer a “soft landing” for the economy as they raise rates in the face of a myriad of challenges: going too slowly may cause the current inflation to persist, while going too quickly may cause a recession. All told, we remain cautiously optimistic, and while my buddy in manufacturing may be right, inflation could stick around and be more persistent than I (or many others) thought, we still don’t believe this will be the main topic of the day a few years from now.

—Best regards, Michael