What is...? Inflation

The World Cup this summer threw off our newsletter scheduling a bit, as school is now well in session and we have yet to do a “What is…?” newsletter.  But fear not! This one has been a long time coming - we tried looking back to see which previous newsletter promised this current one, but stopped when we looked back through four to no avail.  But better late than never, as they say, so without further ado: what exactly is inflation?

Inflation refers to the increase of prices over time.  It also refers to the decline in purchasing power of a currency over time.  In fact, those are exactly the same thing, it’s just that one is viewed through the lens of the object being bought (demand) and the other is viewed through the lens of the object doing the buying (supply).  Tomato, tomato.

Remember when candy was a nickel?  And now the best you can do is like, two for a dollar, maybe, if you’re at Cracker Barrel?  Maybe you can find an individual Reese’s peanut butter cup for a quarter. Remember when gas was less than $1.00/gallon?  Most of you should, because it was only a couple decades ago. What about postage stamps at 32 cents? (Yes, we know they used to be even less than that, no we don’t remember it.)  Or a gallon of milk at whatever a gallon of milk used to cost that’s cheaper than what it costs today? That’s inflation. The prices of goods have gone up across the board. Or, said differently, the purchasing power of the dollar has gone down, so you need more dollars now to buy the same stuff.

Why does this happen?  That’s a tricky one. From an “object doing the buying” standpoint, changes in inflation happen because of changes to the monetary base (how much money is in circulation), which is regulated by the Fed.  The more dollars that are floating around, the more inflation you will tend to get. (Geek’s note: there is a concept called the velocity of money that comes in to play here - it’s not just how much money is in the system, you also need to account for how many times a single dollar will change hands.  If you flood the system with money but that money doesn’t ever change hands, you won’t see any inflation. And that’s pretty much the story of the last 10 years.)

From the “object being bought” perspective, however, it could be any number of things.  Perhaps your price goes up because of trade tariffs. Maybe a hurricane wiped out most of the orange crop this year so your OJ cost goes up.  Maybe Kylie Jenner tweeted a picture carrying your new handbag. Maybe there’s increased regulation costs because the government of California decided that since free oxygen radicals can cause cancer, any packaging that encloses air and is not vacuum sealed must contain a Prop 65 warning and so you have to retrofit all your assembly lines with a little sticker robot.

The reality is it’s some combination of both of the above supply and demand views, along with certain factors like wages and interest rates and the forever unquantifiable aspects of personal preference that economists refer to as “elasticity”.  That’s why some things (healthcare, education) can have significantly higher inflation rates than others (wages). But whether or not inflation is actually predictable and measurable (spoiler alert: not), the Fed in their omniscience has decided that 2% is what inflation should be year over year.

The way they measure this is by looking at a broad basket of goods that get grouped together and called the PCE (Personal Consumption Expenditures), not to be confused with the CPI (Consumer Price Index) that was used previously and is still the more popular inflation measure.  The main difference is that the actual basket of goods that comprises the PCE can change month-to-month because of that elasticity thing we mentioned earlier, whereas the CPI is a fixed basket of goods. The net result is that PCE shows lower inflation over time relative to CPI.  The cynics among us would suggest that this is hugely self-serving for the government - if they can show a lower measure of inflation, then cost of living increases to social security payments can be reduced, tax bracket adjustments can be reduced, etc. But this is not an April newsletter, so we won’t indulge those considerations.

In any case, a bit of inflation is a good thing for those saddled with fixed debt.  If the purchasing power of your dollar is decreasing over time, then really those debt payments you’re making every month are worth less and less.  On the flip side, any kind of inflation is terrible for people trying to saving money and those with fixed incomes, such as a pension. As the years go by, that monthly check buys less and less of the things you used to buy with it.  And on the saving front, money in a bank account at 1% interest does nothing for you if your dollar is losing 2% per year to inflation! Inflation is the reason that cash is a terrible long-term investment.

At this point, we would like you to look left, look right, and simply note the rabbit holes that lead to hyperinflation on the one side and stealth taxes on the other.  We are not going to take you down these rabbit holes at the moment, but if you have a free minute this weekend, go ahead and search “wheelbarrow of cash” or “inflation stealth tax” and enjoy.  At the moment, we’re going to dive right in to the rabbit hole in front of us: the Baba Yaga that is wage inflation.

An idealized economic cycle looks like this:  the economy slows, or goes into a recession. The Fed cuts interest rates and/or in modern times dumps money into the economy out of helicopters.  Lower absolute interest rates are theoretically stimulating to the economy (creating demand, which leads to higher prices and inflation) and from the “object doing the buying” perspective, more money in the system also leads to inflation.  So you get economic growth, but also eventually inflation. To stop inflation and put to bed the specter of the ‘70s, the Fed hikes rates. This slows and/or removes money from the economic system, causing the economy to slow and eventually go into another recession.  Rinse and repeat.

Given the $3.5 trillion (with a “t”) the Fed has pumped into the economy in the last 10 years, people have been expecting inflation to run rampant.  All that extra money floating around, and yet, inflation has been nowhere for a decade (because - geek’s note reference - the velocity of money has been off-the-charts low).  At least, nowhere according to the official government inflation statistics of PCE and CPI. We would argue that inflation has popped up in the stock market, in luxury collectibles, in housing prices, in education...but none of that really gets counted.

In any case, inflation broadly defined is less important than wage inflation specifically.  If the price of things you have to buy at the store goes up, that can always be passed off as a temporary effect and not real inflation.  But if the labor market is tight enough that wage inflation starts occurring...much like the proverbial canary in the coal mine, wage inflation is being viewed as the precursor to broader inflationary ripples getting sent out through the economy, and the first cracks that would signal we’re getting to the end of this current economic expansion.  The idea goes something like this: despite unemployment being really low at the moment, the lack of inflation means that there is still “slack” in the labor market, meaning it’s okay if monetary policy is overly accommodative. Wage inflation, however, would signal that there isn’t much slack at all in the economy, meaning we’re close to full employment, and an overly accommodative monetary policy is going to stoke 1) problematic future inflation 2) potentially late and drastic Fed action to try and keep the inflation Boogeyman under control, 3) fears of an impending recession, and 4) a euphemistic “re-rating lower” of the markets (read: drop).

In other words, wage inflation is the difference between being on the Titanic April 10th and April 14th (and no, it’s not lost on us that being on the Titanic April 10th probably meant you were also on it April 14th.  Unless for some reason you had a Southampton-Cherbourg ticket.)

Remember that big market selloff in February?  January wage inflation came in at 2.9% vs. expectations of 2.7%.  Then in March, February wage inflation came in at 2.6% vs expectations of 2.8%, and the market was up 1.7% that day. As wage inflation goes, so goes the market - just, you know, opposite.

The problem here is that, much like for the official inflation statistics, the process is kind of a joke.  What the BLS (Bureau of Labor Statistics) uses as the basis of those wage inflation numbers is hourly earnings.  But they don’t actually collect hourly earnings data, they collect weekly earnings data and introduce a guess of “average number of hours worked per week” into the mix to backtrack out hourly wage data. Well isn’t that a standard 40 hours per week, you might think?  Nope. Every month for the last 7 years it has been between 34.3 hours and 34.6 hours per week. (Keep in mind that 0.1 hours is 6 minutes). So rather than just using the weekly numbers for comparison, the BLS implies that they can accurately measure work weeks for the entire country down to a six-minute interval and therefore present hourly data comparisons.  Right.  (Okay okay, to be fair, it’s probably less an actual guess and more a random number generator in Excel within some predefined bounds.)

So those hourly wage inflation data points for the first quarter of the year - 2.9%, 2.6%, 2.7% - when viewed on a weekly instead of hourly level become 2.8%, 2.9%, and 3.3%.  All because the average work week in February was estimated as being 6 minutes longer than February 2017, and the one for March was 12 minutes longer than in March of last year.  One of those data series looks to have a much more established trend than the other. Can you imagine what would have happened in February with a 3.3% wage inflation print?!

The upshot is, inflation is coming.  In fact, it’s already here and the market just hasn’t seen it yet.
 
At some point this year, it will happen.  One month will randomly have a work week that is 12 minutes shorter than it was last year, which will likely cause a wage inflation print over 3.5%, and then all hell will break loose.  In the markets, anyway - think February 2.0. Your day-to-day life will be pretty much completely unaffected, provided you don’t have CNBC squawking at you in the background. Or if all hell doesn’t break loose, at the very least you’ll need to find a Tangina Barrons to tell those inflation specters to go into the light.

Did we stretch that Poltergeist analogy a little thin?  Probably, but we’re only a couple days away from October, so deal with it.  Think of it as October inflation...with some poetic license.