Inflation worries bubbled to the surface with the release of the April Consumer Price Index. You can see it filtering into consumer confidence as the University of Michigan index of consumer sentiment had an unexpected drop due to inflation expectations measuring at their highest level in 10 years. It’s important to look under the hood and see if the headline number is telling the whole story and if expectations meet reality.
On Wednesday, the U.S. Bureau of Labor Statistics released the April Consumer Price Index data to some shock and awe. The Consumer Price Index (CPI) increased 0.8% on a seasonally adjusted basis for the month, which translated to an index increase of 4.2% over the trailing 12 months. That is the largest 12-month increase since a 4.9% increase for the period ending September 2008. Core CPI, which excludes more volatile food and energy prices, rose 0.9% in April and 3.0% over the past 12 months; this was its largest 12-month increase since January 1996. The print seemed to send the stock market lower as the major stock indexes fell 2%+, led by the Russell 2000 small cap index which declined 3.25% on the day.
CNBC and every other financial outlet ran with overheating stories, but the report should have been expected. From our Weekly Strategic Insight on April 11:
“These inflation fears are likely to grow over the next several months as economic activity normalizes, and prices normalize along with it. The headline Consumer Price Index (CPI) inflation may likely increase to 3.5% year-over-year in May, which would be the fastest pace in 10 years, while core PCE is expected to reach 2.3%, which would be the fastest pace in 13 years. However, it would be premature to read too much into these inflationary readings. Over the next several months, we will likely witness a multi-month price level adjustment, which may feel like a shift higher in inflation. However, over the second half of 2021, as the economy further normalizes, subsequent growth in economic activity and prices will likely moderate and bring the inflation rate back down to trend.”
Granted, 4.2% is higher than 3.5%, but we’re in the ballpark. Let’s unpack the data to see if anything has changed and if the multi-month price level adjustment thesis still holds.
First and foremost, if you rewind 12 months, the U.S. was in the depths of the COVID-19 pandemic and the economy was broadly shut down. Prices are bouncing off that bottom; therefore, the year-over-year measurement is flawed at best and misleading at worst. Approximately 1% of the 4.2% increase can be explained by a low base comparison.
Second, most of the increase can be ascribed to just a few categories of goods and services. Barron’s has done some great reporting on the idiosyncrasies of the inflation data measures. Used vehicle sales and “reopening categories” of spending, which includes hotels and motels, food away from home, car rentals, event admissions, auto insurance, and airline fares, are typically only 13% of the CPI, but accounted for more than 60% of the monthly increase.
Used vehicle sales, which increased 10% during April, were the largest single contributor to the rise in CPI. Car rental prices cratered during the coronavirus pandemic and caused large rental companies to sell hundreds of thousands of units from their fleets to consumers in the used vehicle market. As demand has recovered, the rental companies have been franticly trying to rebuild their fleets, driving up the prices of both rentals and used vehicles. Auto manufacturers were also forced to scale back production of new cars because of a semiconductor shortage, while demand for cars surged as consumers received multiple rounds of stimulus checks. These dislocations should not inform us of anything regarding the broader state of inflation or macroeconomic conditions.
Although the Federal Reserve uses “core” personal consumption expenditures (PCE) prices rather than CPI, reports like this could start to apply some pressure on the Fed to either taper bond purchases or raise interest rates quicker than forecast. However, Fed officials have been effusive with the view that price pressures are transitory. Following the CPI release, Federal Reserve Gov. Christopher Waller stated, “that despite the unexpectedly high CPI inflation report, the factors putting upward pressure on inflation are temporary, and an accommodative monetary policy continues to have an important role to play in supporting the recovery.”
While I am pointing out the issues with CPI, we can all see anecdotal evidence of price increases, whether it’s lumber (spot prices are up roughly 78% YTD), gas (national average over $3 for the first time since 2014), housing prices (Case Shiller US National Home Price is up 12% year-over-year), and job openings/starting pay. So, I do not want to seem dismissive of the potential for inflation pressures. However, the reopening of an economy coupled with massive fiscal stimulus packages were always going to marry up to create some price increases and supply/demand dislocations.
What we want to focus on are inflation measures that could make the Fed react, intermediate to long term trends, and correlation with interest rate moves.
On that front, the New York Fed developed another inflation measure back in 2017 called the Underlying Inflation Gauge (UIG) with the purpose of measuring the trend and behavior of inflation.
Core CPI only focuses on price components. The UIG derives trend inflation from a large set of data that extends beyond price variables. Additionally, it has shown higher forecast accuracy and some leading indicator qualities compared to traditional core inflation measures. As you may note below, the latest UIG reading for April is 2.68%, which falls below both headline CPI of 4.16% and Core CPI of 2.96%.
Last, interest rates have remained stable. The yield curve had been steadily steepening with the rise in the 10-year US Treasury yield, but since March, the 10-year yield has maintained a trading range of 1.6-1.7%. Longer term rates have been very similar with the 30-year US Treasury yield between 2.3-2.4%.
For now, I think we can anticipate a transitory rebound in the inflation rate in the 3.0%-4.0% range in the coming months before it settles back down closer to the 2.0%-2.5% target.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist