Understanding inflation is important to interpreting labor
market conditions.
It also affects one's perception of income trends and
consumers’ well-being.
Inflation distorts the economy and masks economic incentives.
It makes market price signals unreliable.
It distorts investment decisions and creates risk.
Inflation isn't always measured year-over-year.
Generally, one will hear the year-over-year increase and the monthly increase. One
will also frequently hear a reference to the month-to-month change in the
annualized monthly rate.
Regarding the impact of supply chains on inflation, it
is important to remember that price is always the product of the interaction of
supply and demand. Quite often those who blame supply for the current inflation
are trying to deflect attention away from their own actions which create demand
beyond the economy's capacity to deliver.
Some components of the inflation are highly volatile
while others change more slowly and arguably more persistently. Further,
inflation can be measured in a number of different ways. However, the CPI is a
widely quoted and easily understood measure of inflation.
Those who would like to minimize the perception of the
negative effects of inflation will often quote data that is not inflation
adjusted. By doing so they can often make the disastrous results of policies
look positive. In order to look through this political propaganda, it is often
necessary to go to the source data.
To illustrate this twisting of the meaning of data
consider the following:
“Over the past 12 months, average hourly
earnings have increased by 4.7 percent.”
(Source: Employment Situation Summary,
Bureau of Labor Statistics@ Employment
Situation Summary - 2021 M13 Results (bls.gov)
And from another report:
“The Consumer Price Index for All Urban
Consumers (CPI-U) …. Over the last 12 months, the all items index increased 7.0
percent….”
(Source: Consumer Price Index News
Release, Bureau of Labor Statistics@ Consumer Price Index
(CPI) News Release : U.S. Bureau of Labor Statistics (bls.gov)
Reporting these data separately makes it possible for the
current administration to point to the 4.7% wage growth in dollar terms as if
it were progress. However, when the two reports are considered, what is really
being reported is an over 2% (4.7%-7.0%) fall in real wages over a period of 12
months. If one cares to look at the detail of the data, one also finds that the
fall in real wages is even more severe for wage earners and clerical workers:
“The Consumer Price Index
for Urban Wage Earners and Clerical Workers (CPI-W) increased 7.8 percent over
the last 12 months….”
(Source: Consumer Price Index News Release, Bureau of
Labor Statistics@ Consumer Price Index (CPI) News Release : U.S. Bureau of
Labor Statistics (bls.gov)
That conclusion is based on data from one single agency,
The Bureau of Labor Statistics. These two particular reports were chosen
because they are considered timely and authoritative, and they are both from
the same federal agency. However, they are not the only sources of data that
confirm the trend of falling real wages.
For example, there is the Wage and Salary component of
the Gross Domestic Product (GDP) reports and the GDP Deflater. The Department
of Labor also publishes the Employment Cost Index. However, both of those sources and a number
of other very comprehensive sources suffer from the amount of time taken to
generate them and methodological quirks needed to accommodate their intended use. Nevertheless, they make it clear that wages
are not keeping up with inflation. A timelier source is the Current Population
Survey. The Atlanta Fed uses it to construct a Wage Growth Index that is fairly
timely. It too shows that wages are not keeping up with inflation.
So, for a very large portion of the population that
works for a living, wages aren't keeping up with inflation. They aren't the
only ones. Again, by quoting nominal information rather than inflation-adjusted
information, retirees may be misled about Social Security. Social Security
benefits are increasing 5.9% this year. That sounds good unless one considers
that in the previous year the real value of Social Security benefits decreased
by 7% based on the CPI. However, Social Security beneficiaries are not the typical
consumer represented by the CPI. Medical costs and food represent a larger
portion of their expenditures. The real value of their benefit is being
negatively impacted by inflation despite the dollar increase in the benefits.
Seeing through the fiction that policies are
benefiting people doesn't always necessitate the comparison of different
reports. Take for example the Employment Report, the first one quoted above. Considerable
effort is put into measuring labor market performance in all its dimensions
because of its importance to the well-being of the population.
The Employment Report is based on two sources of data:
the Employer Survey and the Household Survey.
That leaves plenty of room to
spin the data. In some instances, it can make the headline numbers
contradictory.
As discussed in the previous posting, The Employment
Report Simplified, in last month's Employment Report job growth underestimated
the strength of the labor market. This month the number of jobs added to
payrolls is almost the same as the previous month, only about 200,000. Yet, this month the entire report was as
dismal as the disappointing headline jobs number would imply.
However, it was possible to focus on the unemployment
rate as if it indicated strength. In order to do that misinterpretation of the
unemployment rate, one had to ignore a few facts:
“The labor force participation rate was
unchanged at 61.9 percent in December…. The employment-population ratio
increased by only 0.2 percentage point to 59.5 percent in December….”
(Source: Employment Situation Summary,
Bureau of Labor Statistics) Employment
Situation Summary - 2021 M13 Results (bls.gov)
It's one
thing to have anemic job growth when the labor market is expanding because of
increases in labor force participation by self-employment as happened last
month. That's quite a different situation from anemic job growth when the labor
market didn't grow, and labor force participation remained the same.
The
administration chose to pretend that this month's employment report represented
further progress rather than a slowdown in the economy's recovery. Further,
it's a fiction for the administration to talk about creating new jobs when the
number of people employed is still below the previous peak. It is not economic
growth until the previous peak is exceeded. It's just a recovery and a recovery
that is slowing down.
Further, the
job growth number for last month was not revised up enough this month to
reflect a healthy economy. There is a possibility that it will be revised up at
some future date, but for now, the anemic recovery in employment seems to be real.
Also, the December report seems to confirm that the strength of the Household
Survey in the previous report largely reflected people being forced to become
self-employed rather than being attracted to self-employment. In other words,
the good news in the November report was that people were learning to hustle
for a living rather than depending on policy to encourage employers to create
good jobs.
One doesn't
need the complication of the two different employment surveys in order to find
opportunities to spin the data. The same was done with the CPI report. The
headline number was clearly bad news. A 7% inflation rate is not good news
under any circumstance. When one looks at the detail, it appears even worse
than is implied by the headline number. For example, the report showed that:
“Increases in the indexes for shelter and
for used cars and trucks were the largest contributors to the seasonally
adjusted all items increase…. The food
index also contributed….”
(Source: Consumer Price Index News
Release, Bureau of Labor Statistics@ Consumer Price Index
(CPI) News Release : U.S. Bureau of Labor Statistics (bls.gov)
The weighting of different items in the CPI @ 2020.htm : U.S. Bureau of Labor Statistics (bls.gov),
shows that that simple statement implies that the most important items in the
cost-of-living were the ones that were escalating in price the most
In addition, the reported CPI understated the negative
impact of inflation on many consumers. Specifically, consumers looking to buy a
house know that the CPI index for shelter is grossly underestimating the
inflation they are facing. The increase in the component for
shelter would have been much larger if calculated using the methodology in
place before 1982. In 1982 the
methodology was changed to stop using house prices to estimate homeowners’
housing costs. If you're looking to buy house, home prices would seem to be a
more appropriate measure.
House prices were up 19% from those a year earlier, according
to the most recent S& P Core Logic Case-Shiller Composite Index. The
current CPI doesn't use that 19%. Instead, it uses an estimate of what
homeowners would be willing to pay to rent their homes. That estimate was
up only 3.8%. Adjusting the homeowners’ costs for actual prices would have
added 3.5 percentage points to the reported 7% rise in the CPI.
Despite the obvious bad news in the CPI report, the
administration chose to focus on slowdowns in the month-to-month rate of
increase in the prices of highly volatile components like food and gasoline.
However, gasoline and motor fuels have a weighting of only about 3 to 3 1/2% in
the CPI calculation. Gas prices are highly visible but not necessarily
important. They don't represent a large portion of consumers expenditures. Consequently,
the slowdown in the month-to-month rate of increase in gas prices is not
significant, but neither is the doubling of gasoline prices over the last year.
However, calling attention to the slowdown in the monthly rate of increase only
draws attention to the near doubling of gas prices under the current
administration’s energy policies.
The
significance of that policy failure highlighted by the CPI can be minimized by
pretending that the report implied better future news. However, the details of
the report don’t support the argument that the report indicates improvement in
the inflation situation. The inflation situation may improve, but this month's
report didn't show signs of it. A substantial portion of the inflation was due
to major components of CPI and arguably components that are sticky as opposed
to the volatile components. Further, when the rate of inflation goes from an
annualized rate of 1.6% to an annualized rate of 7% during one year of an
administration, it's hard to see how arguing improvement in a single month is
positive. It is clear inflation will be at least 5% or 6% for the next year and
perhaps longer.
The
contortions the administration went through to try to make the current monthly Employment
Report and Inflation Report sound positive only contributed to people's
distrust of the government. They make it clear that the administration sees
economic data as a tool to be used to further its economic agenda rather than as
a tool to be used to formulate those policies. From a politician's perspective,
advancing their agenda might be the appropriate use of the data because
inflation actually short-circuits the ability to use much of the economic data
in formulating better policies.
For example,
retail sales are reported in dollar terms and are viewed as a current indicator
of the economic health of consumers. However, when inflation is important, the
retail sales data becomes difficult to interpret. Is there real growth
represented or is it all just price increases? One cannot use the inflation
data from the CPI to understand that issue. The weights in the CPI don't
reflect current retail sales. In fact, the chain-weighted CPI is specifically
designed to shift the weights to reflect changes in consumption patterns. So,
retail sales data becomes useless as a timely quantitative measure of economic
health of consumers.
There are
alternatives from the National Income and Product Accounts. To adjust for
inflation, one can use the consumer expenditures data after deflating it.
However, what that gains in accuracy is achieved at a considerable cost in
timeliness. Further, even when released, the data are subject to frequent
revisions.
Any data on
economic flows that are denominated in dollars becomes suspect. Can the dollar
value of those flows be appropriately deflated? The CPI, the GDP Deflator,
prices for particular commodities, and prices for selected goods all have to be
brought to bear in order to determine whether a flow represents real change or
just inflated prices.
The same
applies data about stocks of goods and financial stocks. For example, there are
classic accounting problems associated with valuing inventories. One cannot use
the cost of acquiring an inventory as a reliable gauge for its value. That's
always an ongoing problem in business, but inflation just aggravates it.
So, for
example, the preliminary GDP report showed an increase in inventory investment.
This could be interpreted as businesses are starting to stock up and moving
away from just-in-time inventories. However, it could also just be that the
value of their inventories increased due to inflation and that increase in
value is what is being reported. Even switching to a measure of the flow of
dollars into the acquisition of inventories doesn't eliminate the problem. The
increase in the flow dollars in the acquisition of inventories may just reflect
price increases.
The most
basic data can be subverted by inflation. The basic distinction between
consumption and savings can be clouded. While it was a short-term phenomenon,
the fall in retail sales in December after a strong October and November is
being blamed on advanced buying for Christmas. Fears of price increases and especially
shortages, according to this narrative, pushed forward Christmas shopping.
Now that
seems trivial, but rapid inflation can cause people to make purchases as a form
of savings that normally would be considered consumption. We recently ran into
that as people stocked up on certain commodities during the Covid outbreak.
That stocking up was a minor phenomenon, but during the 70s it was not unusual
for people to want to make purchases before prices increased.
The most
extreme form of this occurred during the hyperinflation in Germany when people
would leave work on payday in order to go spend the money as quickly as
possible. In that instance, it may have been for consumption, but it is equally
conceivable that it would simply be a way to invest the money that has a return
that is greater than the zero interest rates currently available on savings.
So, with all
the uncertainty the inflation interjects into the meaning of economic data,
perhaps politicians who view it just as a propaganda opportunity are on to
something. However, if that's the case, it calls into serious question why the
population allows the government to spend as much as it does to generate the
data.
Bad policy
based on bad data is only one of the costs of inflation. Inflation undermines
the basic purpose of prices. Prices are designed to reflect relative value.
However, if all prices are being inflated, the issue becomes whether the change
in price truly reflect an increase in value of the item being priced or just a
decrease in the value of the money. Unfortunately, general price deflators fall
short of being able to sort out relative prices. The basic design of inflation
measures is to reflect overall prices, not changes in relative prices. So,
inflation is like sand in the pricing mechanism of a functioning economy.
Perhaps the
most serious negative impact of inflation is its impact on investments. The
result of that impact is a marked negative effect on the productivity of the
economy through the distortions that inflation introduces into investment decisions.
Inflation makes it hard to interpret investment data.
Its impact on interpreting inventory data has already been discussed. But what
was said about inventory flows being hard to interpret in an inflationary
environment is equally true of flows into any other investment. For example, a
forecast that the stock market will increase in the low single digits implies a
negative real return if inflation is above that low single digit.
A comment about liquidity that could be invested in
stocks has to be adjusted for the decline in the value of those liquid assets
that might be invested. Further, if 7% more money is invested in the stock
market at the end of the year than at the beginning, the real investment is the
same if there has been 7% inflation.
Earnings forecasts have to be adjusted for inflation.
To say earnings will grow at a certain rate has to be explained as either a
dollar rate or a real rate. In a 7% inflation environment a 7% increase in
profits is standing still in real terms.
Every financial
professional is familiar with the concept of a hurdle rate. It's the rate of
return on an investment that has to be exceeded in order for the investment to
be justified. Companies usually measure it as their cost of capital. Investors
measure it against their alternative uses of the money. In both cases,
inflation can set a floor under the hurdle rate.
Consider for
a moment the impact that statement implies for investing. Much of the
literature on investing argues that an investment is justified if its
risk-adjusted expected return exceeds the risk-free rate of return. Previous
postings have argued that the risk-free rate of return is a potentially meaningless
construct without a concrete definition. For example, when discussing solvent
risk on April 1, 2010 in The Hedged Economist: Beware the risk-free return:
“The concept of a risk-free rate of return is like
a cancer that has invaded modern financial economic theory. Usually, Treasuries
Bills are used as a quantitative expression of the mythical risk-free rate of
return. Every time “risk-free” appears in a formula or in print, stop! Ask:
“What does the author really mean? Are they really saying anything? What
concept really should be used? What assumptions have to be made in order for
the formula or phrase to make sense?” All sorts of issues get brushed aside
through the simple assumption that risk-free returns are an acceptable substitute
for addressing some very volatile behaviors.”
Negative
treasury rates should have convinced the academics who publish investment
literature that the concept of a quantifiable risk-free return is highly
suspect. Yet, the concept persists and influences the thinking of central
bankers. Much of their thinking about the impact of interest rates on the
economy hinges on treasuries being a primary competitive alternative
investment. However, investing in treasuries has considerable risk, especially
with zero interest rates. There is the risk that the actual value of the
treasury will fall previous to maturity. But there is also the risk with
inflation that the return at maturity will have been reduced in value. It's
that risk that is being referenced when people referred to the inflationary
expectations having an effect upon long-term interest rates.
Inflation
and the risk of inflation are important components of the risk to treasuries.
In an inflationary environment there are investments with a lower risk than
treasuries. Basically, items that normally would be considered consumption and
are durable or long-lasting have a risk-free return if their price increases
along with inflation. The classic example is the overinvestment in farmland
that occurs in many developing economies during periods of hyperinflation.
One doesn't
need to go to that extreme for examples.
Inflation makes the purchase of commodities viable as a risk-free return
or at least makes them competitive with productive investment. The purchase of
another company with hard assets that won't decrease in value may be viewed as
an alternative to increasing productive capacity. So might purchase of the
company's own stock become appealing if it is expected to increase in value at
least as fast as inflation. It is that cramping of productive investment that
reduces growth during periods of inflation. It's why one can have stagflation
or depressions during periods of inflation.
So, while
inflation may in some cases be a symptom of an overheated economy, it can also
be a depressive that ends the overheating. The risk of that happening is only
increased by the confusion of the data that inflation causes.
During an
expansion, nominal growth, that is growth in current dollar terms, can continue
while inflation is exceeding the growth rate in current dollar terms. This
period of real decline usually appears late in the cycle. From an investment
perspective it's a phase where financial assets, like stocks, can decline even
while the economy is growing. There is a good chance we will witness that in
2022 even though we are still early in the recovery phase of the cycle.
