Inflation: A Little Here, A Little There
Since inflation is heating up, we have dusted off some historical data and are doing our homework. This article breaks down the recent data to give you a picture of where the inflation currently resides. We may have to turn this into a series over the next few months to give you the context and some ideas about where this may be heading. To borrow some language from 2020, are the reports of inflation just a minor outbreak of a new variant or is this a full-on pandemic?
Inflation Sets Multi-Decade Record In April
In April, core CPI jumped to 3.0 percent year-over-year, the fastest pace since 1996. Core CPI increased 0.92 percent from March to April, the largest monthly gain since 1981.
Since we’re talking about inflation, some definition might be useful. The word “inflation” in the U.S. usually means “CPI,” Consumer Price Index. CPI measures the weighted average of prices of a basket of consumer goods and services, such as housing, food, transportation, and health care. Changes in the CPI are used to assess price changes associated with the cost of living. The U.S. Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis and has calculated it as far back as 1913. The “inflation rate” is actually the change in the index from the prior period, whether it is monthly, quarterly or yearly. The word “inflation” means an increasing CPI and “deflation” means a decreasing CPI.
Now, back to April 2021. The market and the financial media seem to think this high inflation number may be the start of a long-term trend of higher inflation. They give the reasons for their thinking: record government spending, easy Fed policy, supply restrictions relative to demand, and ongoing supply bottlenecks. However, a closer look at the data suggests that this spike is actually made of smaller spikes – a little here and a little there – as the global economy moves from pandemic recession/depression to a normal economy.
The Two Parts Of Inflation: Change and Base
Let’s flash back to your junior high (or earlier) math class. When we see a rate of change number like “Inflation grew at X% year-over-year,” there are two parts: the numerator and the denominator. When we read or hear about inflation, the rate of change is the numerator. Rate of change is calculated as current value minus beginning value. The beginning value and the denominator is the CPI reading at the beginning of the period.
Here’s an example. We hear a report that “the stock market is up 50% in the past year.” We should ask ourselves where the market was a year ago. On March 23 2020, the S&P 500 hit the bottom of a pandemic-induced bear market after dropping about 33% from its high. A recovery of 50% means the market has returned to the high it reached pre-pandemic.
Now, back to our inflation discussion. There is an expectation that slightly higher inflation in 2021 would be a result of low inflation numbers in 2020. In other words, the April 2021 rate of change needs to be taken in the context of the beginning value in April 2020 when the global economy was shutdown because of the pandemic.
While the denominator effect from low readings in April 2020 was widely expected by markets, the monthly pace of inflation in April 2021 was still higher than expected. We’ll talk about those details after a brief comment about bonds.
Inflation and Bonds
Bond investors know that inflation decreases the current value of their future interest payments. Therefore, when they get the least whiff of inflation in the air, bond investors will begin to ask for more yield, which drives the prices of bonds down.
This happened when the April CPI numbers were released, despite the Fed repeatedly emphasizing that they view this rise in prices as part of the economic reopening and not as a long term-problem. The Fed holds a lot of power so bond investors would be wise to heed the Fed’s perspective.
The Details: A Little Here…
The month-to-month gains in the April core CPI number were largely driven by a few small categories. By ‘small’ we mean ‘not weighted heavily in the CPI calculation.’ These categories are being heavily affected by the reopening economy and temporary pandemic-induced shortages.
Of the 0.92 month-over-month increase, 0.54 came from used cars, rental cars, airfares, and hotels. These four sub-categories total 59% of the increase but only 5% of the core CPI basket. In other words, these categories overcame their small weight in the Index by experiencing huge monthly price increases. Used car prices were up 10% month-over-month. The other three sub-categories are related to travel, an industry hit especially hard by the pandemic-related drop in demand and now being hit hard by spiking demand. You may have read of the rental car shortage: a Toyota Camry in Maui recently rented for $720 per day. (Rental cars were sold off during the pandemic and car rental companies are slowly buying new cars to lease.) These increases are unlikely to be sustained beyond the next few months as supply and demand level out.
The View From The Temple (The Federal Reserve)
To the Fed, what matters is the trend in the larger, more durable inflation categories that influence the longer-term inflation outlook. In those categories, month-over-month inflation was much more muted. Rents (including owners’ equivalent rent) and healthcare services make up 49% of the core CPI index but were less than 10% of the April monthly gain of 0.92%.
The Long Term
The Fed is more focused on the long term and we should be, too. In future articles, we will examine the root causes of inflation and how it moves through the economy.