Inflation Opinion

By David B. Armstrong, CFA | Dec 14, 2021 | Weekly Market Commentary

At this point, everyone is familiar with the increase in the Consumer Price Index (CPI) and the fact that it is the highest it has been in 39 years. The news is full of all the high-level facts, but I wanted to take a different perspective and dig into it a little bit to provide some thoughts that you may not be reading or hearing about in the news.

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Let’s address all of the talking about the word “transitory”. Since everyone is discussing whether or not the current inflation is transitory or here to stay, let’s start with a quick recap of a recent Senate hearing between senator Toomey from Pennsylvania and the Fed chairman.

Sen. Toomey (R-Pa): “Now, I know you believe this is transitory, but everything’s transitory. Life is transitory. How long does inflation have to run above your target before the Fed decides maybe it’s not so transitory?”

Fed Chair Jerome Powell: “Well, I think it’s, it’s probably a good time to retire that word and try to explain more clearly what we mean.”

Personally, I think this back and forth was nothing more than Chairman Powell telling senators what they want to hear because I’m not so sure I believe this increase in inflation is not transitory.

I’m not an expert—that’s just what I’m thinking.

Here’s why.

It seems to me that a few individual categories explain a lot of the 6.81% year-over-year reported inflation – specifically motor fuels, new and used cars, and rents.

So are we really looking at INFLATION if just three categories out of hundreds explain almost the whole thing?

Here’s a way to look at this…if the 6.81% year-over-year report is compared to the Fed’s 2.5% target rate for inflation, there is a 4.31% spread between reality and the target. So what’s adding to that spread?

• Motor Fuel is the largest component of the 4.31% coming in at 1.61%, then;
• New & Used Cars is 1.38%, and finally;
• Rent at 1.28%…

Add that up and you get (drum roll) 4.27%.

4.31% minus 4.27% is 4 basis points. Basically NOTHING. From this perspective, the whole difference between the Fed target and the actual 6.81% is made up of those three categories.

Before I dive into that, let’s come back to the word “transitory.” For context, the definition is below:

Ok, now be George Costanza for a minute and do everything opposite…what would it mean for inflation to be the opposite of transitory?

For that, imagine out to November 2022…CPI would report a year-over-year change of 6.81%, just like November 2021. That would be persistent inflation…the opposite of transitory.

But for that to happen, price categories in the CPI basket would have to do again in 2022 what they did in 2021.

Motor Fuels

Let’s consider the largest single contributing category to the 6.81% increase – motor fuels at 1.61%. Clearly, motor fuel is driven by the price of oil, which has roughly doubled from the $40s up to the $80s year-over-year. For inflation not to be transitory, oil would have to double again. It would have to go from roughly $80 to $160.

That’s not impossible. But in the world of probable vs. possible, what’s your gut tell you…you wanna bet on that?

Rents

The other category is rents, which is the largest single category weighting in calculating CPI at 32%. Rents closely follow home prices, which have skyrocketed since the pandemic, and the thing is, rents follow home prices with a lag.

So while that likely means rental prices will continue to rise over the coming year and contribute more to inflation in the coming year than in the last year, lets take a closer look at what that would actually MEAN for inflation.

In this chart from Trend Macro, you see the Case Shiller Home Price Index year-over-year in green, and the far right side shows the post-pandemic home price boom. A couple months ago, it was up 20% year over year.

The purple line is an overlay of the year-over-year change in Owners Equivalent Rent (OER). That’s the component of the CPI that represents home prices for people who own homes. This is a little wonky, but home prices aren’t observed directly in CPI. Instead, they look at the price to rent a home, and they assume that if you own your home, you’re implicitly paying that rent to yourself.

Because rental contracts only renew every year or two, the data lags about 18 months.

So that means it’s reasonable to assume this purple line will reach the level of the green line…and if it does, it will likely hit the worst level in the history of data back in the housing bubble with the 2000s orange equivalent rent at 4.3% year-over-year (right side purple scale).

But it looks like if (when) that does happen, it will only tack on 18 more basis points (bps) to inflation because we already have the big move incorporated in the recent CPI…essentially a 3.5% increase year-over-year is already in the 6.81%.

Sure, OER can go even higher than the 4.3% record from the early 2000s…but even an extra 1% on top of the 4.3% gets it to 5.3%…but that adds 40bps vs 18bps.

40bps is nothing relative to the 3.5% increase that just got backed into the 6.81% CPI.

By the way, the Case Shiller rate of change measurement here (again green line and left scale) has actually started coming down…see that hook down on the very right end of the green line?

Looks transitory to me. But wait, there’s more…if you order in the next 15 minutes, I’ll throw in my thoughts on….

Cars

I don’t have a whole lot of analysis here because I think it’s simple – people are buying cars for all the usual reasons, and maybe some people who are scared to take public transportation are buying cars, too. So I’m gonna assume demand is normal. Chip and parts shortages are shrinking the supply side for new cars, which drives buyers to the supply of used cars. Demand > Supply.  My opinion: the supply side will fix itself in 2022.

I don’t see oil doubling from current prices, I think the catch-up increase in rents won’t add much to inflation relative to what it just added, and cars fix themselves in 2022.

It’s not a popular opinion, but it’s MY opinion…inflation is probably transitory.

What am I not factoring in? Build Back Better (BBB) could pump another $2T into the economy. If that happens, my opinion will end up most likely being wrong.

But I think 6.81% CPI just pulled the plug on BBB in 2021 because of one thing…

Well, one person.

Joe Manchin.

Joe Manchin last week on Wall Street Journal CEO Council reminded everyone that 17 Nobel Laureates claimed back in February that the big government spending package would NOT be inflationary. Here’s what he said –

“We had people at that time saying inflation will be transitory. We had 17 Nobel Laureates saying it’s going to be no problem. Well, 17 Nobel laureates were wrong.”

So I think BBB is off the table this year, and since next year is a mid-term election year, it’s not gonna happen then either. Without BBB, I’m fairly convinced that inflation is transitory.

I know I’m in the minority, and I’m no CPI/inflation expert, BUT the Fuel/Rent/Cars contribution and BBB unlikely is what has shaped my opinion.

Since it was a big news event with people taking sides, I thought I’d share my thinking.

Keep looking forward,