The Consumer Price Index (CPI) rose 0.4% in August on a headline basis, a tick higher than consensus expectations of 0.3%. If food and energy are stripped out, prices rose 0.1%, in line with expectations.
On a headline basis this follows an unchanged reading in July and a 0.7% increase in June. On a core basis it follows increases of 0.1% and 0.2% in July and June, respectively.
The rise in the headline number was almost entirely a function of a 9.1% increase in gasoline prices. Food prices rose in line with the rest of the consumer shopping basket, up 0.1%. On a year-over-year basis it is a different picture, with core prices up 1.5%, while on a headline basis the CPI is down 1.4%. Once again, the key difference is energy prices.
Given that the collapse in energy prices happened last fall, the differential in year-over-year prices between core and headline will soon reverse. Over the last year, overall energy prices are down 23.0%, with the biggest declines being in heating oil (-39.9%), residential Natural Gas (-32.7%) and Gasoline (-30.0%). The reason the overall energy index is down only 23.0% is that electricity has only fallen by 10.6%.
However, to take gasoline as an example, most of those declines are about to be lapped. In the three months ending in November 2008, gasoline prices fell at a seasonally adjusted annual rate of 85.4%, and then fell a further 26.6% (annualized) in the following three months. Thus, assuming no change in gasoline prices from current levels, year-over-year headline inflation is poised to shoot higher on a year-over-year basis.
This will seriously undercut the idea that T-note yields are adequate. Right now the argument could be made that on a real yield basis, you are getting more like 5% on a 10-year note rather than 3.5%, because inflation is negative 1.5%. Going forward, that is unlikely to be the case. I really doubt that over the next ten years we will average deflation of 1.5% per year, so T-notes look pretty expensive to me, particularly at the long end.
Turning to other items, the prices of medical commodities rose 0.5% for the month and are up 3.7% year over year, while the cost of medical services rose 0.2% for the month and are up 3.2% year over year. It seems like regardless of the economic climate, medical costs are always going up by more than overall inflation.
With the drop in home prices over the last year (heck, the last 3 years) one might expect that the cost of housing might be coming down, but “not true,” say the government stats. That is because in the CPI, the price of a house is completely irrelevant to housing prices. Rather they assume that you rent your house to yourself, and so it is based on a survey of people asking them what they thought it would cost to rent an equivalent house in their own neighborhood.
This owners equivalent rent (OER) rose 0.1% for the month and is up 1.7% year over year. OER is by far the single biggest item in the CPI, at 21.4%. If you add in the regular rent that people pay to their landlords, it adds another 8.3% of the index.
Since OER and regular rent are neither food nor energy, they make up an even bigger part of core inflation, about 28.5% for OER and 11.1% for regular rent, or almost 40% overall. Given the commentary from REITs that specialize in apartments — such as Equity Residential (EQR) and Apartment Investors (AIV) — about getting lower effective rents, I suspect that both the OER and regular rent components of CPI are too high.
In other words, going forward, I would expect higher headline inflation numbers, and lower core inflation numbers. We started to see that this month on a monthly basis, but the year-over-year figures are still being dominated by the events of last fall.
If one breaks down the year-over-year decline in headline inflation of 1.4% into the six months ending in February (-5.0%) and the last six months (+2.3%), this becomes very clear. Core inflation has also picked up a bit when broken down that way, rising at a 1.1% annualized rate in then first six months, and at 1.9% over the last six months.
But the swing is much less dramatic ( and the OER caveat still applies). The big difference is energy commodities, which fell at a 66.3% annualized rate through 2/09, and rose at a 42.2% annualized rate over the last six months.
I think that energy prices are likely to continue to head higher as the world economy recovers. A weak dollar will also pressure oil prices higher. However, it will be a long time before enough slack is taken out of the economy (we will see about capacity utilization and industrial production later today, and 9.7% unemployment is certainly a lot of slack) for wages to rise.
The net effect of the higher headline inflation will be a decline in the real standard of living. We will not get a wage-price spiral like we had in the 1970’s, simply because there is no way for the wage side to get any traction.
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