Inflation seems to be the topic du jour in the market right now. First, understand that there is a lot of noise around inflation right now for one obvious reason: comparisons to one year old levels. Of course there is inflation when looking at June 2021 versus June 2020. Due to the Covid-induced economic lockdown that took hold last year, prices were deeply depressed. Now, as the economy reopens and pent up demand takes a hold of the economy, inflation is surging. But how much inflation is solely due to year ago comparisons versus long-term secular trends?
Inflation is measured via CPI
The consumer price index (CPI) is the most common measure of inflation that you’ll read about in the financial media. CPI measures average price changes for a market basket of goods, such as the price of gas, groceries, clothes, and airline fares, among other consumer spending categories. The latest CPI reading showed that prices rose 5% over the last 12 months. That’s the highest rate of change since 2008:
Here we would reiterate that these readings have to be taken with a grain of salt. The price of gas, for instance, was very low one year ago. Many people were confined to their homes during lockdown so very few people were driving. Thus, demand was low. The same is true of airline fares; no one was flying. Fast forward one year and the price of gas has risen nearly 50% and is nearing 10 year highs. In addition, airfares are near 2019 levels or even more expensive. Used cars, in some instances, are selling for more than the original price of the car. These are all examples of inflation and are contributing factors to a hot CPI reading.
The question becomes what will happen to the data when we move beyond comparisons to the depressed Covid level readings. Unfortunately, due to the nature of the pandemic last year, and the varying responses between states, the data could remain lumpy for some time. Florida, for example, was pretty opened up by August 2020. California, meanwhile, didn’t fully reopen their economy until just this month.
Explaining away inflation
Quite frankly, there are a lot of strange things that could be muddying the data right now. One example is a global chip shortage that has greatly impacted the auto industry. Due to this shortage, the auto industry has been unable to produce the amount of cars they usually would. The chip shortage is thought to be temporary, but it could be one reason used car sales are surging right now. Industry experts expect the impact to subside by the end of the year.
Even though air travel demand has not fully rebounded to 2019 levels, it is growing rapidly month over month. Among the factors impacting prices is the limited number of routes available. In fact, American Airlines just cancelled hundreds of scheduled flights due to being understaffed. It’s expected to be some time until the airline industry gets back to 100% flying capacity as measured by scheduled flights.
Some have commented that it is hard to tell how long-lasting this recent demand surge will be versus how much it is just travelers making up for lost time.Many people didn’t fly for a year and are eager to take trips right now.
But will that sustain? Or is there likely to be some pullback as people return to a more normal lifestyle? The airline industry isn’t sure of that answer just yet and they are using the uncertainty in their favor when it comes to pricing power in the immediate term.
It stands to reason that as more months go by and the airline industry can better map out demand, as well as work out some of the corporate kinks that come with accelerating their business back up, airfare prices should stabilize.
“Sticky-Price” CPI could be more useful
One of the criticisms of the CPI reading is that it is too volatile to accurately reflect real inflationary pressures. For some of the reasons we just outlined, some say CPI doesn’t do a good job of capturing long-term inflation trends. There is merit to this argument. Food and gas prices for example, a key component of CPI, can vary greatly from month to month or year to year. So what might be more useful for determining long-term inflation versus temporary inflation? Enter the Sticky Price CPI.
The Sticky Price CPI was introduced in a 2010 research paper by two economists at the Federal Reserve of Cleveland. They took the CPI and broke it into two subindexes: flexible and sticky. Flexible prices are those of goods whose prices can be changed easily and thus are more likely to be changed frequently. Sticky prices are those of goods whose prices are harder to change and are thus changed infrequently.
For context, consider how easy it is for a grocer to change the price of milk (flexible CPI) versus how cumbersome it is for a city like Chicago to change the price of public transit (sticky CPI). Other goods that are grouped into the Sticky Price CPI are motor vehicle fees (think license plate renewals), trash collection services, and home and auto insurance.
As the research paper explains:
While a sticky price may not be as responsive to economic conditions as a flexible price, it may do a better job of incorporating inflation expectations. Since price setters understand that it will be costly to change prices, they will want their price decisions to account for inflation over the periods between their infrequent price changes.
In summary, these economists argued that Sticky Price CPI does a better job of capturing long-term inflation trends.
Sticky Price CPI is rising rapidly
The Sticky Price CPI, in the last 3 months, has risen at its fastest pace since 1991, though the 12-month comparison isn’t quite at 2008 levels:
The takeaway is that, at least over the last few months, there is evidence from the Sticky Price CPI that the economy is entering a higher inflation regime. It’s important to note that a “higher inflation” regime should not be confused with a “high inflation” regime. Inflation has been very subdued overall ever since the 2008 financial crisis. The decade of 2010-2019 saw the lowest average annual inflation since the 1950s:
So we could see inflation over the next 12-24 months come in at 2-3% and that would be higher than the last 10 (and possibly 20) years, but it would still be below the long-term average of 3.10%. That would also, at this moment in time, be our current expectation. We think it’s pretty clear that over the next 1-2 years, and possibly longer, inflation will be higher than we’ve been accustomed to over the last decade. However, we think it’s too early to say if inflation will go from being “higher then it was,” to just plain high. But in analyzing the situation, we’ll be paying closer attention to indicators like Sticky Price CPI, more than the headline CPI number that the news media will likely be fixating on in the months ahead.
In conclusion, popular measures of inflation such as CPI are showing there is a lot of inflation taking place right now. But at least some of these inflationary pressures could prove to be temporary as industries readjust to the current state of the economy. We believe a more accurate measure of long-term inflation pressure is the Sticky-Price CPI, and while it is rising rapidly in the short-term, one-year comparisons are still relatively muted. For further reading on certain investments that may perform well during an inflationary cycle, check out our latest articles discussing gold and treasury inflation protected securities (TIPS).
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