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August 25, 2018

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Here Comes INFLATION

August 25, 2018

Earlier in August, the Bureau of Labor Statistics released their monthly Consumer Price Index (CPI) report.  The report, used to measure change in prices for a basket of goods over time, is highly watched by economists and researchers alike to gauge the current state of the economy.  The higher the CPI reading, the more that goods and services will cost the consumer to purchase.  The report showed that the CPI has increased 2.9% over the prior 12 months (before adjusting for seasonality). The same index less food and energy increased 2.4%. Over the past twenty years inflation has been relatively modest, typically anywhere between zero and four percent annually.  Although zero inflation sounds great, it typically implies that people aren’t earning more over time and that the economy is stagnant. On the flip side, a higher inflation number typically signals that the economy is firing on all cylinders, that unemployment is low, and wages are increasing at a fast pace. Although there is no perfect inflation number, current policymakers have targeted an inflation amount of around 2% annually.

If no inflation is bad, then high inflation is worse. Nothing can derail an economy faster than high inflation. A high inflation rate means that your dollar won’t go as far as it used to as the prices you pay for goods and services increases. The mere thought of higher inflation can send asset valuations lower. This is because if there’s higher inflation, the Federal Reserve will most likely raise borrowing rates in a hurry, sending bond prices sharply lower and causing people to pull money out of equities. This is what happened in early February of 2018. The worry of inflation sent the stock markets into a sharp selloff, causing a 10% decline in equity markets.

 

A key determinant of inflation is the labor market. A lower unemployment rate typically means more people are working and receiving a steady paycheck, which should allow them to spend more money. With a current unemployment rate of 3.9%, the United States labor market is in the best shape that it’s been in over the last 20 years. The unemployment rate has been steadily trending downward ever since late 2009 when it peaked at 10% and it doesn’t seem to be slowing. This alone should be a concern for policymakers as there is an increased amount of money being moved around in the economy. The counter argument to current concerns over inflation is that wages haven’t been increasing fast enough to spur inflation. But looking at just the wage growth in the country to determine the future of inflation would be a mistake. Just as the government and central banks have different levers they can pull to stimulate or slow the economy (think interest rates, bond purchases, budget deficits, and tax rates), so too does the consumer.

 

If history has taught us anything it’s that Americans don’t like to save money. They especially don’t like to save money towards the end of bull markets. Why? Because consumer sentiment is high. People don’t see any risks within the economy and they’re living in the moment. According to the U.S. Bureau of Economic Analysis, the personal savings rate in the United States in December 2002, just before the Dot-com Bust, was a paltry 4.2%.  And prior to the Great Recession in November 2007, the savings rate was a trivial 3.1%. In June of 2018 this rate stood at 6.8%, much higher than rates prior to past recessions. Take a look at the chart below to see how savings rates typically go lower prior to a recession.

 

 

Although the current savings rate looks great for the individual American (and it is), it also means that Americans have the ability to decrease their savings rate in an effort to generate cash flow. This will, in turn, allow them to increase spending on goods and services. According to Trading Economics, Americans have roughly 15.5 trillion dollars of disposable income per year. Using the current savings rate of 6.8% we can conclude that Americans save about one trillion USD per year. Should the savings rate drop to even just 5.0% over the next year, the drop would inject an additional $280 billion into the economy, causing inflation to surge.

 

What other levers can consumers pull to generate additional spending money? Just as governments can sell assets in times of want, so too can consumers. With equity markets at record levels there is a tremendous amount of wealth tied up in equities. Should the masses decide to sell some of these financial securities they could quickly raise billions in cash for purchases, again causing inflation to soar.  One last tactic is through borrowing. Household and non-household debt has risen for 16 consecutive quarters. According to the Federal Reserve Bank of New York, the most recent number as of June 30th, is that Americans owe $13.29 trillion, which is over $600 billion more than prior to the Great Recession. As Americans are willing to take on an increasing amount of debt, the nominal prices of goods and services should continue to rise.

 

 

One other possible catalyst to inflation is the recent reduction of effective tax rates. At the beginning of the year something miraculous happened to me.  I started receiving roughly $40 more per paycheck. I wasn’t sure what was going on. Did the payroll department make a mistake? Did I receive an early raise and my manager forgot to tell me? No to both, I’m not that lucky. After a little research on Financial Fixation I found out that the tax cuts had gone through and new withholding amounts were calculated by my company’s payroll department. This recalculation allowed me to receive additional money in my bi-weekly paycheck. I wasn’t the only one that received these tax cuts, however. Most middle-class wage earners received similar cuts and should see a slight benefit in every paycheck moving forward. This new money won’t show up in traditional wage growth numbers. That’s because the top-line wages didn’t increase. I did receive less of a tax bite though, and due to this I’ve been receiving more money on a bi-weekly basis. I now had an extra $80 a month burning a hole in my pocket. What was I to do? How about pass these savings onto the producer, via purchasing more goods and services.  As the tax cuts have only been in effect for about half of the year, consumers haven’t fully allocated this newfound capital back to the retailers. Give it a few months and you’ll really start to notice the impacts.

All in all, decreased unemployment rates that generate even modest wage growth, coupled with a decreased personal savings rate and increased consumer debt will result in an accelerating inflation rate. Although we have yet to see a decrease in savings rates, should historical trends resume, we may see inflation creep up at a quicker pace. Throw in decreased effective tax rates for individuals, increased trade tariffs, and a somewhat accommodative Federal Reserve and you have the cherry on top of an all-too-expensive inflation sundae.

 

 

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