Composite Inflation Index Warning Of Slower Economy
However, it is important to understand that the methodology of the inflation calculation that is in use today significantly understates the real rate of inflation. This was done in order to suppress the cost of living adjustments in social security payments. The original calculation was based on a basket of goods that were repriced each year and was a much more accurate gauge of actual inflation.
This is why in the recent debt ceiling debate one of the ideas that was proposed was to make further methodological adjustments to the CPI calculation which would save $300 billion a year for the next 10 years. The only way that you can make that statement is that if you know in advance that the changes will artificially suppress the result.
Today's release, however, reflected a broad jump in inflationary pressures despite the recent drop in energy prices. Following yesterday's surprise increase in PPI it was expected that CPI would come higher than expected. What was surprising for the markets was that there was a 0.7% swing month-over-month which was the highest in years. Headline CPI can in at 0.5% in July after dropping -0.2% in June, or 3.6% year-over-year. This was far more than consensus which expected 0.2%.
However, take a look at where the inflation showed up - Gasoline, food and clothes. "The gasoline index rebounded from previous declines and rose sharply in July, accounting for about half of the seasonally adjusted increase in the all items index. The food at home index accelerated in July and also contributed to the increase, as dairy and fruit indexes posted notable increases and five of the six major grocery store food groups rose...The apparel index continued to rise sharply, increasing 1.2 percent in July; it has increased 3.9 percent over the past three months....The index for nonalcoholic beverages increased 0.9 percent in July as the coffee index continued to rise sharply."
As you can see in the chart above the actual inflation rate is over 11% annualized which reflects the real stresses on the average American's ability to make ends meet. We have seen in recent releases of personal savings and credit that savings are once again being drawn while credit is increasing as the real effect of higher costs of living eat into stagnant wages and salaries.
Our composite inflation gauge has now, at least temporarily, peaked at levels that are normall consistent with economic slowdowns. Normally, when this gauge peaks at these levels and turns down the economy is either in, or soon will be in, a recession. The only time this did not occur was during the economic growth spurt that was driven by the massive credit induced/mortgage equity withdrawal boom during 2006-07. Unfortunately, the pain was only delayed a while before it set in with a vengeance in 2008.
There are three important points to note about CPI as it relates to the average American consumer:
- The methodology was changed to suppress real inflationary pressures to allow for lower cost of living adjustments in entitlement payments.
- The current impact of higher food and energy prices is much more important than the media and economists give it credit for. While the food and energy component is volatile the core rate does not accurately reflect the pressures on the consumer. The consumer is being pressured into a defensive posture and in turn this is being reflected in the economy.
- The year-over-year trends in inflation are much more critical than the month-to-month variations in prices. Consumers don't look at raw data - they live in a world with a fairly strict level of monthly income and expenditures. When inflationary pressures through higher utility costs, apparel costs (sharply higher in today's report), gasoline and food costs rise markedly other consumptive behaviors must be adjusted. Therefore, the annualized trends are much more critical to determining the impact on consumptive behaviors.
While we do NOT expect any type of hyperinflationary threat in the economy anytime soon, as there are still many deflationary pressures in the economy such as housing, wages, services, etc., we do feel that the commodity based inflation is severe enough to crimp economic growth. This, of course, leads to concerns about the future growth in asset prices as the markets will have to adjust for lower earnings growth.
With consumers under an onslaught of pressures from either unemployment or concern about their jobs, lower housing prices, higher costs of living, lack of credit and political concerns it is not surprising that the economy is on the brink of a secondary recession. Any more domestic, financial, or geopolitical shocks and the we could see a severe crack in the financial markets. We continue to recommend higher levels of cash and fixed income until some clarity can be obtained.