The Consumer Price Index (CPI) rose by 0.3% in August, matching its July rise. In June the CPI was down 0.1% and year over year it is up just 1.1%. Almost all of the increase was due to energy prices, which rose 2.3% on top of a 2.6% increase in July, but after a 2.9% decline in June.
Year over year, energy prices are up 3.8%. Actually the increase is even narrower than that, as energy commodities such as gasoline were up 3.8% on the month, on top of a 4.0% rise in July but after a 4.1% fall in June. Energy service prices, like electricity and piped gas service increased just 0.4% after being up 0.8% in July and down 2.1% in June. Food prices were relatively well-behaved, rising 0.2% for the month after falling 0.1% in July and being unchanged in June. Year over year, food prices are up 1.0%.
Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were unchanged in August, down from a 0.1% increase in July and up 0.2% in June. Year over year, core prices are up 0.9%. 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.
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 the Case-Schiller index. 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 25.21% of the CPI, or more than food and energy combined.
Regular rent, paid by tenants to landlords makes up another 5.97% of the overall CPI. The two rent measures tend to move closely together and combined make up 31.2% 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 — 40.1%.
Regular rent fell 0.1% in August after increases of just 0.1% in each of the prior two months, and is unchanged over the last year. OER was unchanged on the month after also being up just 0.1% in both June and July, and is down 0.3% over the last year.
The use of OER rather than directly tracking housing prices makes for a much more stable CPI. If housing prices were directly measured, such as in 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.
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 will 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.
Risk of Deflation Greater than Inflation
Right now, the risk of deflation is greater than the risk of run away inflation. This report does little to alleviate those fears, although the somewhat hotter than expected PPI yesterday did help a bit (see “Producer Price Index Up 0.4%”). We are not in it yet, at least as measured by core prices, but we are uncomfortably close.
The threat of deflation is one of the reasons that long-term T-note yields are so low. A return of under 2.7% 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. If it were to average what it has since 1988 (the period covered by the graph above, 2.9%) you would actually lose purchasing power by locking up your money.
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 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. 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 short Treasury ETF (TBT).
Where Do Price Increases Exist?
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 0.2% in August, but that simply reversed a 0.2% decline in July and came after they were unchanged in June.
While year over year they were up 3.0%, if the pace of the last three months were sustained, there would be no inflation at all in the price of medical commodities. 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 Pfizer (PFE) and Merck (MRK) 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) also were up 0.2% in August after being unchanged in July but up 0.4% in June. Year over year, medical service prices are up 3.2%, but if the last three month pace were maintained, they would only be up 2.4%.
The other noteworthy area of inflation is in car prices, particularly used car prices. In August, the price of a used car rose 0.7%, and that is on the heels of a 0.8% increase in July and a 0.9% increase in June. Hey, at least the trend is in the right direction. Still, we are talking about a 15.5% rise over the last year. In contrast, the price of new cars rose just 0.3% after back-to-back increases of 0.1% in June and July.
Year over year, new car prices are up 2.3%. While that is still more than the overall rate of inflation, which indicates more pricing power on the part of Ford (F) than the average company has it pales in comparison to the jump in used car prices. The differential seems obviously unsustainable to me, but yet it persists month after month.
That is probably good news for the big used car dealers like CarMax (KMX). However, if it were to continue for a few more years, a 1999 Ford Escort would cost more than a new Ford Focus. Somehow I don’t see that happening. What we are probably seeing is a large “inferior good” effect. In other words, in tough times people gravitate to buying the cheaper product, even if is of inferior quality. Used cars relative to new cars meet that description.
Overall, this was a fairly solid report. It does not totally put to bed the danger of deflation, but it does not further fan the worries of it. It certainly does not raise the specter of run away inflation anytime soon. It will not resolve the debate within the Fed about resorting to unconventional methods of increasing the money supply by buying up large quantities of long-term T-notes, but is probably a minor argument in favor of doing so.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
FORD MOTOR CO (F): Free Stock Analysis Report
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