Will inflation continue to rise? Yes says a Duke finance professor who explains why
At first glance, the August Consumer Price Index (CPI) report, compared to the fever that has raged over the past few months, did not appear dire. The overall reading of 8.3% showed a small increase of 0.1% which, combined with a similar drop for July, marked a two-month flattening in price. That’s a big pullback from the super hot trend for the first half of 2022, a time when the CPI was rising an average of 1% per month, or an annualized clip of 12%. But a CPI that continued to move sideways was not the good news investors expected. The July data had fueled optimism that the Fed’s interest rate hikes were already taming the beast, the peak had passed and consumer prices would fall significantly in August, sending the US on the brink. well on the way to the Fed’s 2% target and creating space for the central bank to relax. When the Sept. 13 data disappointed, Wall Street bulls pulled back, sending stocks to their biggest one-day selloff in more than two years.
In reality, the outlook for the coming months is worse than the “no increase” August figures that have so shaken investors. Going forward, we will likely see the CPI return to the pattern of serial increases. The reason? Housing costs, by far the main force in the evolution of the CPI, are already rapidly increasing Americans’ living costs. But because of the way they’re measured, a lot of those increases aren’t yet counted in the index. “This component is growing and will continue to grow,” says Campbell Harvey, professor of finance at Duke University. “It’s inflation that’s happened before, but it’s not yet reflected in the CPI. This is part of the reason why future inflation will be high and persistent. The view that the story is all about supply chain and political risk, and that we will quickly drop back to 2-3%, is wrong.
The CPI methodology makes it highly likely that the number will remain high in the coming months
Harvey distinguishes between two factors that will determine future CPI readings. The first are what he calls the “mechanics,” or how the CPI is calculated. These levers pretty much set the numbers for the next few months in stone, and they’re not pretty. The second are “structural” factors dominated by the rising tide of housing and rental costs that will increasingly inflate the readings over a longer horizon.
As for the mechanics, Harvey explains that the year-over-year change in inflation depends on two things: how big the month-over-month increase was 12 months ago and the rise of the current month. When the current month’s increase is less than the previous year’s increase, the annual CPI “observation” must fall. This explains the dramatic drop in July which raised high hopes. Prices rose by that tiny 0.1%, and since the July 2021 rise was a much larger 0.48%, the index fell from 9.1% in June to 8.5%. Similarly, in August, the 0.1% increase was less than the 0.30% gain in August 2021, triggering a smaller decline to 8.3%. Simply put, the bigger the month-over-month increase a year ago, the more the CPI will fall if the current month is stable. These mechanisms explain the drop from 9.1% to 8.3% from June to August.
But 8.3% is still a huge and troubling number. So what are the mechanics telling us about where the CPI will head in September, the last reading before the November election? Let’s make the hopeful assumption that inflation runs at an annual rate of 3% in September. This would add 0.25% to prices compared to August. Given that the increase in September 2021 was an almost identical 0.27%, inflation would remain exactly the same at that alarming 8.2%. Using the even rosier forecast that prices remain stable at August levels in September, the number isn’t much better at 8.0%. Bad readings are baked for months to come. If prices rise at that 3% annualized rate through December, the CPI that month would register 7.6%, nearly four times the Fed’s target.
Housing prices will keep inflation high for a long time
The Bureau of Labor Statistics methodology for measuring housing costs explains why they are not fully reflected in the current index and will keep it high for a long time. “Shelter” has by far the largest weight in the CPI at 32%, eclipsing foods ranked #2 at 13%. The BLS uses two measures for “housing” expenses, based on surveys of 50,000 residences. The first is the “rent of the principal residence”. This is what apartment dwellers or single family home renters are currently paying, in the month that is being measured. For homeowners, the BLS does not use home prices, which have risen nearly 20% overall over the past year. Instead, it’s rolling out “owner-equivalent rents.” To get these numbers, the BLS takes what renters are currently paying for apartments and adjusts those payments based on the size, age, renovations and neighborhoods of homes to calculate what homeowners would pay to rent their abodes. . Indeed, the growth of the institutional single-family home rental market is a good indicator for this calculation.
This methodology takes into account the large disconnect between what people are paying right now on their current apartment leases, or a hypothetical lease for a single family home, and what a family is paying right now for a new lease – in d ‘other words, the current, real – hourly cost of housing. For the past year, the Zillow rent index has posted double-digit increases. In August, the year-over-year number was 12.3%. At the start of this year, increases in the cost of housing according to the CPI were at an annualized rate of 3% and 4%. In August, the number was around 7%. “Here’s the difference between today’s housing costs and the CPI number,” says Harvey. “If you signed a 12-month lease in October 2021, your rent is blocked until October. New rents go up double digits, but you don’t pay the extra. Then you get a new lease in October and your rent goes up, say, 10%. You take this hit all of a sudden. Harvey says these continued increases, as more leases are renewed at much higher rents, will close the gap between current CPI numbers and much higher market rents, pushing the index on the rise.
A combination of rising rents and food prices will keep inflation entrenched
Housing costs decrease somewhat. In recent months, Zillow’s increases are closer to around 10%. Still, this is much higher than the 7% reported by the CPI over the past two months. At one-third of the index, a 10% increase in “rents” equates to a 3% annualized increase in the CPI, and for Harvey, recurring, built-in increases of this size are likely to last for up to a year. year. . The catch is that energy, the famous force that has kept the headline CPI constant over the past few months, is unlikely to make the same contribution to lower indices in the future. “Gasoline is only 5% of the index, but it almost solely explains the slightly negative overall reading in July and August,” Harvey says. In August alone, gasoline fell 10.2%. “I don’t think we’ll have the same weight of a gasoline price crash again,” he adds.
By contrast, food prices increased at an annual rate of almost 10% in August, after a 13% jump in July. “I don’t see any indication that the rise in food prices is abating,” Harvey said. “The index could start rising again, unless we get another big drop in energy prices.” By mid-2023, Harvey predicts, inflation will still be well above the Fed’s comfort level, at well over 4%. The main factor likely to keep the CPI up is catching up on these underestimated housing costs. This is the spoiler that optimists miss.
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