Inflation Apparently is a Thing of the Past

11 Dec

The market continues to push into new territory of all-time and multi-year highs, yet it also appears to be putting positive spins on negative data releases and attaching itself to positive economic data. Housing weakens here; manufacturing slowdown there, retail sales disappoint here and inflation isn’t moderating over here. That is all I heard last week, but it seems as if not too many people are picking up on it. More importantly, it’s almost as if the market just kind of forgot about inflation being a factor in the market.

Maybe it has. Maybe the market decided that inflation is not a factor in short term market pricing. It would not be uncommon for the market to ignore data, but I believe the market shouldn’t be ignoring inflation at this juncture because its critical to the Federal Reserve who controls the United States’ monetary policy. Fortunately, I don’t think I am alone in this view either.

On Tuesday November 28th, 2006 Federal Reserve chairman Ben Bernanke gave a speech in New York about the current economic outlook. In that speech he shared some thoughts that were fairly observable. One of the phrases that stuck with me was that “the level of the core inflation rate remains uncomfortably high”. To me, that means the Fed is still keeping a close eye on inflation data and that any spike in the data may spark some disconcerting discussions or even an over-due drop in the market. One statement does not make a speech, but when he continued and said that “the FOMC reiterated its view that the upside risks to inflation are the predominant risks to the forecast and indicated that it is prepared to take action to address inflation if developments warrant” in its latest statement, it got me wondering. This is not the first time Fedspeak has conjured up uncomfortable thoughts about high inflation over the past six months, but I believe the market has almost completely ignored some of this.

Quite possibly, the market may be interpreting the data incorrectly or not at all and instead focusing on corporate earnings (which I feel have already been priced in) and a soft landing. Who knows? To paraphrase John Maynard Keynes, the market can react irrational for an unknown period of time. Maybe the Fed’s inflation data isn’t the most accurate. For some reason, I feel like inflation is hitting me harder than the inflation data estimates. I consider myself part of the minority who actually saves and is not an exuberant consumer that is overfeeding the economy, therefore, I closely watch what I am paying for everything. In either case, here are a few more thoughts.

You may or may not “penny watch” as I do, but some interesting things have been happening over the past 12 months. Gas prices have doubled (and at certain times have even tripled), clothing has become more expensive, the price of cereal has gone up, the price of milk has gone up, yogurt and bread are more expensive and candy bars will soon be $1.00. Not all prices have risen; technology products such as computers, software and televisions offer you more for your dollar today than they did last year. These are just a few of the everyday prices I have noticed jumping more than the 2.7% inflation rate the Fed is measuring.

The fed typically uses the core CPI year over year data to gauge inflation (plus a multitude of other facts and figures), but the core number came in at 2.7%. I feel my personal consumer price index (PCPI) is much higher. In fact, let’s talk about the CPI number for a minute.

For some reason or another, it is hard to believe the current core CPI data. First of all, core CPI does not include energy prices or food prices, yet this is where I have noticed a surge in prices. It is illogical to not include two of the most essential everyday goods when measuring inflation. Below is a sample of some of the 200 item categories and complementary goods that are used to calculate the CPI (Department of Labor Statistics). From this small sample, these prices seem to have increased more than 2.7% over the past year.

Let’s just go through a few of these items that I recently purchased that have increased in price. I used to be able to buy 10 Yoplait yogurts for $5.00, but now I pay $6.00, or a 20% increase in price. A gallon of store-branded 1% milk was $2.69, now it’s $2.99, an increase of 11%. Every four weeks or so, I visit Great Clips because of its cheap, quick and convenient hair cuts (even though sometimes, I wish they did a better job cutting my hair), but the last time I went in, the cost of a simple haircut had also increased from $13 to $14 or an 8% increase. The price of first-class stamp increased earlier this year from $0.37 to $0.39 (a 5.4% increase) and according to the USA Today, there are talks about raising it another $.03 or 7.6% in the next 12 months. Fortunately, gasoline prices have moderated back to modest levels that were also seen in 2005 (although, prices are still up 50% since 2002). The price of my medium vanilla latte at the coffee shop down the store increased the price of the $3.49 coffee to $3.79 or 8.6%. Heck, even the burrito vendors outside of the downtown bars at 2 AM have increased their burrito prices from $2 to $3, or 33%. According to my small sample of goods, my personal consumption price index or PCPI is sitting at 13.6%.

It’s not that my PCPI make up a truly comparable inflation figure, but my point is prices everywhere are going up. It’s not only energy prices, its also food prices and services. Energy prices have moderated, but are still at risk to move higher. Wheat futures are up 42% since the start of the year and corn futures are up 74% on the year; both give an indication of the food prices you will pay in the grocery store. The labor market has tightened as the unemployment rate has dropped to 4.4% (the lowest level since late 2001) and that means employers have to pay their employees more as they try to retain their qualified and talented employees. In effect, many parts of the economy are experiencing the inflation effects of higher costs.

In fact, there is one piece of data that I think has come to the forefront of my mind. It came across me when I was reading John Mauldin’s newsletter from Millennium Wave Investments. By paraphrasing the details of the inflation measure and the chart below, the “Trimmed Mean PCE” is a new monthly inflation number that the Dallas Federal Reserve economist, Jim Dolmas, has developed. Jim, like me, believes that food and energy prices have meaning in the real world and have therefore included them in this number. Effectively, the trimmed mean calculates a very similar number to the personal consumption expenditures (PCE); however, it is calculated by trimming a certain number of lowest and highest values and then computing the remaining to achieve a mean number. Below is the Dallas Fed’s Trimmed Mean PCE number compared to the PCE and PCE excluding food and energy.

* Note: PCE stands for Personal Consumption Expenditures. It is simply a measure of goods and services geared toward a typical individual and consumed by an individual. It is collected and reported by the Bureau of Economic Analysis of the Department of Commerce.

I believe this is a better measure for inflation. You can see that the trend has moderated over the past few months (most of this is due to the large drop in energy prices), but this by no means that inflation is not a factor. Instead, the moderation is still above the Fed’s “comfort level” and will remain because of high commodity prices, a tight labor market and volatile energy prices. Keeping an eye on this data is important and it is critical for the market to be aware of higher inflation. We will see it all pans out, but I would like to see continued moderation in inflation; otherwise a market will begin to take notice again like they did late spring.

Charlie Santaularia

Managing Director

Parrot Trading Partners, LLC

cell 785.766.0773

office 303.284.9232

www.parrottradingpartners.com

charlie@parrottrading.com

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