In distinct contrast to yesterday’s PPI report, the Consumer Price Index (CPI) shows that at the consumer level, inflation remains very tame. In January, the CPI rose 0.2% on a headline basis, and if volatile food and energy costs are stripped out to get core inflation, it actually fell 0.1%.
Headline inflation is not only low, but also extraordinarily stable, having spent five straight months at the 0.2% level, which would annualize out to 2.4%. The actual rise over the last year is 2.6%. On a core basis, the 0.1% decline this month reversed a 0.1% increase in December, and core prices were unchanged in November, so over the last three months there has been no core inflation at all.
Over the yast year, core prices were up 1.6%. While the core number strips out food and energy, food really isn’t that much of an issue, up 0.2% in January after back to back 0.1% rises in December and November, and actually down 0.4% from a year ago.
Energy the Main Factor
The big inflationary factor really just boils down to Energy, where prices were up 2.8% on the month (and no, that is not an annualized figure) after a 0.8% increase in December and a 2.2% rise in November. Over the last year, overall energy prices are up 19.1%. But even that does not tell the full story.
It is really energy commodities, like gasoline and heating oil, that are driving things, not energy services like electricity and piped natural gas. Energy commodities were up 4.9% in January after a 1.6% increase in December and a 3.0% rise in November, and are up 46.6% from a year ago. Energy services, on the other hand, were unchanged in January after a 0.3% decline in December and a 1.1% increase in November and are actually down 4.7% year over year.
Energy commodity prices are really just a function of the price of oil (with some minor modification for things like the crack spread that refiners make turning crude into products consumers actually use. Crack spreads, by the way, have been lousy — much to the detriment of firms like Valero [VLO]) and Tesoro [TSO]).
It is the upstream part of the energy business that has been getting the benefit, especially if they are able to boost their production. One smaller name in that seems to fit the bill is ATP Oil and Gas (ATPG).
The graph below shows the course of consumer inflation since 1983 (i.e. excludes the high inflation 1970’s and early 1980’s so you can see the changes better). The red line excludes only energy, since that is the real culprit in what inflation we have. Note that aside from energy, consumer inflation is near its lowest year over year level on record (OK, its about at the same level it was in the Kennedy Administration, if you want to be a stickler about it).
Another area of persistently higher prices is in Medicine, but nothing quite as dramatic as in Energy (then again, a year ago energy prices were tumbling, and medical costs never seem to go down much). Medical commodity costs (i.e. drugs) rose 0.7% in January. In December, a 0.1% decline in medical commodity costs cancelled out a 0.1% rise in November.
Over the past year, medical commodity prices are up 3.5%, or 36.4% more than overall inflation, and 87.5% higher than core inflation. Medical services (i.e. doctor and hospital visits) were up 0.5% in January, following increases of 0.2% and 0.3% in December and November, respectively, and are also up 3.5% over the last year. Clearly, in the absence of health care reform, the medical sector has far more pricing power than do other areas of the economy. Two drug companies that look interesting here are Gilead Sciences (GILD) and Dr. Reddy’s (RDY).
Other CPI Factors
What is really holding down the overall CPI is the cost of shelter, which fell 0.5% in January, after being unchanged in December and down 0.2% in November. Over the last year, overall shelter costs are down 0.1%. That is important since shelter has a huge weight (32.3%) in the overall index.
By far the most important part of shelter is owners equivalent rent (OER), which is what the government figures you are paying yourself for living in the home you own. It alone is 25.2% of the overall CPI, and of course, it is neither food nor energy, so its influence on core prices is even higher. Together, food and energy make up 23.3% of the CPI, or less than OER alone.
Rent that tenants actually pay landlords is an additional 6.0% of the index. OER fell 0.1% in January after being unchanged in December and falling 0.1% in November. Tenant rent followed a similar path, being unchanged over the last two months following a 0.1% decline in November.
OER is down 0.1% over the last year, while regular rent is up just 0.1%. Given the overall weakness in the housing market and the huge number of vacant houses and apartments, the real mystery is why rents have not fallen (at least as measured by the BLS) more than they have. My guess is that both types for rents will stay low or negative for a very long time, certainly through the end of 2010. That, in turn, will keep the CPI, particularly core CPI, very low.
Don’t Misread the Fed’s Action
The Fed’s raising of the discount rate should thus probably not be interpreted as a signal that they are going to tighten overall monetary policy anytime soon. The discount rate is supposed to be a penalty rate, sort of the equivalent to banks of having to go to a payday lender because you can’t find any reputable source to borrow from.
The penalty was removed during the crisis last year to remove the stigma from banks using the window. The stigma still remained, and as a result the Fed had to come up with an alphabet soup of new liquidity programs (i.e. the TALF) to get the banks to come borrow from it without the markets being spooked by a bank actually going to borrow from the Fed. The conditions in the credit markets are back to normal, so at this point the Fed would rather that banks borrow from the private markets the way they are supposed to in normal times.
There is still a huge amount of slack in the system. Yes, the unemployment rate ticked down to 9.7% in January after peaking at 10.1% in October, but it remains far too high. The rate of capacity utilization is just 72.6% overall — well below the 80.6% long term average rate — and in manufacturing it is just 69.2%.
While the capacity utilization rates are up from their lows in June, they remain extremely depressed. By all three of those measures of slack in the economy, we are still at the worst levels ever seen since WWII prior to this downturn, with the exception of a few months in the depths of the Reagan Recession. With inflation not a major near-term concern, and massive amounts of slack in the system, it would be pure malpractice on the part of Dr. Bernanke to administer any tightening medicine.
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.
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