Inflation: As 'Contained' As An Arrow From A Bow

By: Michael Ashton | Fri, Feb 17, 2012
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Is 15 months in a row of rising core inflation 'contained?'

Year-on-year core CPI has now risen for 15 consecutive months. At some point, it will seem reasonable to let it have a month off, but until now it hasn't needed it. Fifteen months in a row. That's impressive. It's so impressive, in fact, that it hasn't happened since 1973-1974, when prices were catching up from the failed experiment of price controls imposed by President Nixon in 1971-73. Core inflation has never, in the history of the data (which exists since 1957), accelerated for 16 consecutive months. So, next month we have a chance for a record!

Headline inflation was softer-than-expected by 0.1%, even as the NSA CPI index itself came in higher-than-expected. As I pointed out yesterday, that was a semi-predictable consequence of the change to new seasonal adjustment factors. Core inflation was 0.218% month-on-month, however, which actually generated a rise in the rounded year-on-year index to 2.3% (2.277% to three decimal places). The table below shows the evolution of the year-on-year changes for the eight major subgroups from 6 months ago to 3 months ago to last month, to now.


  Weights y/y change prev y/y change 3m y/y chg 6m y/y chg
All items 100.0% 2.925% 2.962% 3.525% 3.629%
Food and beverages 15.0% 4.212% 4.452% 4.470% 4.001%
Housing 40.2% 1.876% 1.874% 1.869% 1.453%
Apparel 3.5% 4.664% 4.573% 4.194% 3.056%
Transportation 16.5% 4.961% 5.197% 9.185% 11.980%
Medical care 6.9% 3.605% 3.491% 3.116% 3.199%
Recreation 5.9% 1.372% 1.027% 0.253% -0.173%
Education and communication 6.7% 1.838% 1.670% 1.371% 0.982%
Other goods and services 5.3% 1.740% 1.701% 1.660% 0.847%


Compared to last month, Apparel, Medical Care, Recreation, and Education/Communication accelerated, groups which total 23% of the consumption basket. Transportation and Food & Beverages both decelerated, and they total 31.5% of the basket. Now, notice that Transportation and Food & Beverages are the two groups that are most affected by direct commodity costs - energy and food, respectively. So...don't get too excited by the deceleration there, although new and used motor vehicles and other components of Transportation also decelerated and that doesn't have much to do with energy prices. In Food & Beverages, "Food at home" is decelerating (about 57% of the Food & beverages category) while "Food away from home" and "Alcoholic beverages" (the balance of the category) are accelerating.

Yes, you can get eyestrain looking too closely at these figures, but doing so does help.

For example, one theme I think the Fed is counting on is that the "Housing" component of CPI is expected to decelerate due to the still-high inventory of unsold homes and the fact that foreclosure sales can now proceed. It has been a conundrum why rents have been rising while home prices stagnate (actually, not much of a conundrum: there is an underlying inflation dynamic that in the case of the housing-asset market is being overwhelmed by a decline in multiples. But this is a conundrum to the Fed, and to be fair I also expected Housing inflation to be lower than it has been recently). And in this month's data, you can see that the year-on-year increase in Housing CPI flattened out. But, as the table below shows, the Shelter component wasn't what flattened out. Housing only went sideways because the "Fuels and Utilities" component declined - again, a commodity effect.


  Weights y/y change prev y/y change 3m y/y chg 6m y/y chg
Housing 40.2% 1.876% 1.874% 1.869% 1.453%
Shelter 30.92% 1.983% 1.905% 1.792% 1.399%
Fuels and utilities 5.27% 1.941% 2.432% 3.483% 3.201%
Household furnishings and operations 4.03% 1.035% 1.000% 0.561% -0.224%


I still expect Housing inflation to level out and probably to decline, but so far those expectations have been dashed. It will be uncomfortable for the Fed if it remains this way; a significant part of their expectations for a visually-contained core inflation number is (mathematically) due to the expectation that housing inflation isn't going to keep rising. As you can see in the chart below (Source: Enduring Investments, the rest of core inflation outside of Shelter is continuing to rise. Inflation is not 'contained', except maybe for housing. Maybe.

Core Ex-Shelter

I am fairly confident, though, that if Housing inflation does not decelerate as expected, then the Fed will find some other reason to ignore the very clear acceleration in inflation. The economists at the FRB are for the most part true believers in the notion that the output gap constrains any possible acceleration in inflation, despite ample evidence that output gaps don't matter (or, anyway, matter far less than monetary variables). For another view of this proposition, see the Chart below, taken from this article by economist John Cochrane.

Inflation and Unemployment: 1985-2011
Larger Image

Fed economists also feel strongly that "well-anchored inflation expectations" means that they can ignore 15-month trends in core inflation, despite the fact that by Chairman Bernanke's own admission we aren't really very good at measuring inflation expectations (to be kind).

They have time. The Fed has recently begun to treat 2% (on core PCE, not core CPI) as more of a floor than a target, so it will be some months, even if core inflation doesn't pause for a month or two pretty soon, before the Committee starts getting at all warm under the collar about inflation. Even then, they are extremely unlikely to take steps to reduce liquidity while Unemployment remains high. The Fed is in a political bind, and the only easy path for them is to "see no evil" on inflation while hoping that Unemployment drops swiftly enough for them to act before prices really get out of hand. We will see.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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