Inflation has been a hot topic of conversation over the past few months. Everyone has an opinion whether inflation is good or bad, helps or hurts, is dangerous or sustainable. It can be overwhelming to decipher what impact it will have on their lives.
What has happened with inflation?
COVID negatively affected the global supply chain, or how goods get from raw materials to finished, and then into the hands of retailers and consumers.
There are two primary measurements we use to gauge the pace of inflation: the producer price index (PPI) and the consumer price index (CPI). In a nutshell, PPI reflects the cost for manufacturers to convert raw materials into finished goods and CPI reflects the final price consumers pay for those products. Of these two indicators, the primary focus is on CPI because it is an interest rate policy factor for the Federal Reserve, it directly impacts “transfer payment” adjustments such as Social Security, and it is a better representation of producer costs that can be passed through to consumers.
Core CPI is the most watched, as it excludes the more volatile inputs of energy and food. Over the 12 months through April 2021, the annual change in core CPI averaged less than 1.5%. In April and May 2021, core CPI spiked to 3.0% and 3.8%. These increases have brought attention to inflation on the investment radar.
Why is the change in inflation important and how does it affect consumers?
A small change or a short-lived change in any inflation component typically has a minor impact on consumer activity or standard of living. Foremost within living standards are food, shelter, and clothing. These three areas make up about 60% of the CPI, with housing being 42% of the 60%.
Housing prices are based on rent, and the owner’s equivalent of primary residence (OER). These figures are based on surveys of owners and renters in urban areas. With that in mind, increases in lumber and other manufacturing costs generally do not impact rent numbers, or OER. Housing costs generally track supply and demand for apartment and house rentals, and since most renters are not in month-to-month contracts, short-term spikes have less impact.
Currently, COVID uncertainties, employment changes, crime increases, and protests in major urban centers have reduced demand for rental units, mitigating upward pressure on rent prices. Food and beverages make up 15% of the CPI and is based on a “basket” of goods. Only long-term changes in producer level prices tend to show up as long-term changes in this component of CPI, primarily because of substitutes. For example, when beef prices rise people tend to buy more chicken, etc. The near-term impact will be dependent on regional, even local, market factors, and likely be felt more in the cost of food than in the cost of rent.
For people buying new homes, increases in lumber may only have a marginal negative effect on affordability, given that mortgage rates are so low and over 30 years, $25,000 in lumber equates to an average higher payment of roughly $200 a month.
Medical care cost inflation is all too familiar to consumers, but we have not seen a major spike. Nor has that been the case with recreation or education this year.
Credit card delinquencies are the lowest they have been in the past three decades. The government sent 185 million stimulus checks worth $850 billion, directly to U.S. consumers. Also, the cost of money and credit in general is the lowest most people have seen in their lifetimes. So, while low interest rates will not reward savers (deposits, CDs or money market), it is helpful in most other ways, including the cost of auto, mortgage, home equity, education, and credit card loans.
Some shipping costs surged 500% above the seasonal average for the past five years. Close to 80% of all international trade of goods is shipped by sea. These costs will not be minimized quickly because of continued operational disruptions from COVID, container displacements, and overloaded ports as industries return to normal conditions. We are likely to see significantly higher costs of many goods as producers pass as much of their own price increases through to consumers until mid- to late-2022. This inflation will be the most realized by consumers who are regular consumer of non-basic items or products made outside the country.
Calming considerations
The primary reason CPI’s annual change is well above average is that April and May 2020 were high points of fear and market impact, and current prices are being compared against those low points. One of reasons we say mid-to late-2022, is that annualized comparisons will reflect current levels in the denominator, and it’s hard to imaging another 500% increase in shipping costs a full year hence, as global challenges are overcome and competition, as well as supply and demand, work to bring markets closer to equilibrium again.
Consumers have choices. Individual budget impacts vary widely and are largely dependent on choices consumers make. For example, they can choose new versus pre-owned cars; eating out versus dining in. Credit card delinquencies are at a 30-year low, and the personal savings rate is 15% as of April (including 401k, IRA and other retirement accounts) (Source: Factset). In our view, consumers recognize the crisis period we’ve been in and have adjusted their budgets and saving accordingly.
Markets love cheap money and rising employment. The advice “don’t fight the Fed” has proven fruitful to those who have followed it. Despite a sentiment change which acknowledges inflation inputs and more than $5 trillion of federal stimulus, the fact remains that the cost of capital is low, liquidity and credit opportunities abound, and more people are getting back to work every month.
Consistent increases in inflation often drive the Fed to increase policy rates to curtail inflation, but that hawkish cycle tends to run over several years, not months, and equity markets tend to rise during that process. On a fundamental level they gain because employment is also growing, increasing consumer spending and putting more capital into the hands of public and private companies, which in turn can further increase employment and investment.
COVID has impacted so many sectors of life over the past two years. Its presence has spiked a sudden increase in inflation, and whether it is a blip or a long-term trend is still unknown.
