Wednesday, September 21, 2016

Inflation: Healthy & Unhealthy

Bob Wiley, the anxiety-prone obsessive-compulsive character played by Bill Murray in “What About Bob?,” tells his psychiatrist, played by Richard Dreyfuss, “There are two types of people in this world: those who like Neil Diamond, and those who don’t.”

Previously, I’ve often argued that there are two kinds of deflation. In a period of good deflation, consumer prices fall as a result of competition, technological innovation, and productivity. Consumers’ purchasing power increases and they spend more, which results in more demand and more jobs. The standard of living improves.

Bad deflation typically occurs after a prolonged period of easy credit. The stimulative impact of easy credit is increasingly dampened by the burden of accumulated debt, which weighs on demand. Meanwhile, supply is plagued by too much capacity as easy money allows the living-dead “zombie” producers to stay in business. Zombies are very sociable. They create more zombies as profitable companies become unprofitable competing with them. Debt servicing becomes more onerous as the profits recession is exacerbated by falling prices. A dangerous deflationary spiral is often triggered by the bursting of speculative bubbles that had been inflated by easy money.

There are also two kinds of inflation. There’s the kind that stimulates demand by prompting consumers to buy goods and services before their prices move still higher. The other kind of inflation reduces the purchasing power of consumers when prices rise faster than wages. That variety of inflation certainly doesn’t augur well for consumer spending.

During the 1960s and 1970s, price inflation rose faster than interest rates. The Fed was behind the inflationary curve. So were the Bond Vigilantes. However, wages kept pace with prices because unions were more powerful than they are today, and labor contracts included cost-of-living adjustments. Back then, the University of Michigan Consumer Sentiment Survey tracked rising “buy-in-advance” attitudes. Those attitudes remained particularly strong in the housing market through the middle of the previous decade. On balance, inflation stimulated demand more than weighed on it. Borrowing was also stimulated.

Today, the major central banks would like to revive buy-in-advance attitudes, along with inflationary expectations, to boost demand for goods and services. For various reasons, the central bankers have failed to increase their inflation measures back up to their 2.0% targets. Despite several years of ultra-easy monetary policy since the financial crisis of 2008, the ECB’s preferred measure (i.e., the headline CPI) has been under 2.0% since February 2013, and was up only 0.2% y/y through August. The BOJ’s preferred inflation measure (i.e., “core” inflation excluding only food) has been under 2.0% since April 2015, and was 0.5% through July.

In the US, there is some confusion about whether Fed officials are targeting the headline or the core PCED inflation rate. In the past, they all seemed to focus on the core rate excluding food and energy. More recently, even individual FOMC participants have mentioned both as worth monitoring. In any event, both remain below the Fed’s 2.0% target, with the headline at 0.8% and the core at 1.6%.

A few Fed officials believe that the core is close enough to 2.0% to hike the federal funds rate again soon. Others say that having stayed stubbornly below 2.0% for most of the time since October 2008, what’s the rush to raise rates? This afternoon, we will all find out whether the doves or the hawks won the debate at the latest meeting of the FOMC.

Both sides are missing an important development on the inflation front. The variety of inflation that the US is experiencing isn’t the kind that stimulates economic growth. On the contrary, it has been led by rising rents, and more recently by rising health care costs. It is very unlikely that buy-in-advance attitudes cause people to rent today because rents will be higher tomorrow, or to rush to the hospital to get a triple-bypass today because it will be more expensive tomorrow! Higher shelter and health care costs are akin to tax increases because they reduce the purchasing power available for other goods and services. Consider the following:

(1) The rent is too d@mn high! Tenant rent accounts for 5% of the core PCED and 10% of the core CPI. In August, it was up 3.8% y/y in the CPI, well ahead of the increase in the core rate. That can’t be good for consumers’ purchasing power given that a record 37% of all households were renters during Q2-2016. The tenant-rent data are used to construct owners’ equivalent rent (a very strange concept, indeed!), which accounts for 13% of the core PCED and 31% of the core CPI. It was up 3.3% y/y during August, the highest pace since June 2007. Why would anyone at the Fed think that’s a happy development, since it doesn’t really have any effect one way or the other on anyone, because what homeowners rent their homes from themselves!?

(2) Obamacare’s stealth mission almost accomplished. Of course, 100% of households rely on our health care system. August’s CPI had some really bad news on this front. There were big increases in health care prices as the overall health care index jumped 1.0% m/m (the most since February 1984) and 4.9% y/y (the highest since January 2008).

It’s not clear why the surge occurred during August, but it may be related to the expansion of healthcare coverage under Obamacare. There has certainly been an increase among the population with pre-existing conditions, which has significantly boosted costs for all. Many conservatives always suspected that Obamacare was designed to fail so that the government would have to save the day with a nationalized single-payer system.

By the way, one of the main reasons that the CPI inflation rate exceeds the PCED rate is because the latter doesn’t include health care spending paid for by the government through Medicaid and Medicare. Nevertheless, when August’s PCED is released on September 30, it may very well hit the Fed’s 2.0% target thanks to rapidly rising rents and health care costs. For the man and woman on the street, congratulations to the Fed will not be in order. However, I won’t be surprised if Fed officials jubilantly declare: “Mission accomplished!”

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