The Turn of the Screwflation

Inflation/DeflationBig Lou’s Pizza in San Antonio gives new meaning to redefining the size of a pie.

At 42 inches, their large pizza could easily feed a famished family of six. Or a hungry herd of eight. Or perhaps just a sampling score of nibblers if they’re satisfied with a simple starter. That’s the beauty of the world’s biggest pizza pie – you can divide it into as few or as many slices as fits the bill.

If only household budgets were nearly as compliant in a world of slow income growth amid the rising cost of essentials. This taxing environment was actually given a name by a good friend, hedge fund manager and world thinker, Doug Kass: “screwflation.” No soul has yet to top the characterization.

Today’s consumer price index is a striking case in point for what ails those insulted by news that inflation remains too low. Headline inflation, which is economic speak for the whole enchilada of prices, rose by 1.4 percent over January 2015. And core inflation, which strips out food and energy due to their volatile nature, was reported at 2.2 percent over last year and the highest rate in nearly four years.

Ask any mother who goes through a gallon of milk a day and she’ll happily report to you that three years ago she was spending $4.50 a gallon, two years ago $5.00 and last year $5.50. That’s not volatility. It’s stability in a bad way.

As for those lower energy costs, they are indeed awesome. But reaping great fortunes at the gas pump requires that the cost of bigger line items to not overwhelm what you’re saving. If only life’s necessities came down to that soon-to-be-disposable flat screen TV, we’d all be rolling in excessive disposable income. But the fact is rent has risen to an all-consuming status among budget line items. Of course, housing has always been the biggest line item for the average household. Still, the ranks of renters are unprecedented in modern history; the percentage of households who are renting is the highest in 50 years.

Today’s consumer price index (CPI) also reported that rents are rising by 3.7 percent over the last 12 months. If you get the sense that your rent’s been growing faster than that, perhaps you should consider a figure not imputed by government statisticians.

Axiometrics, whose specialty is tracking apartment rental trends, puts year-on-year rental inflation at 4.3 percent. The good news is January’s rate was flat compared to December and follows three welcome months of moderation. Even better, rent growth has tempered from last January’s 4.9-percent rate. Less encouraging is that rental growth has been running above four percent for 18 straight months, or roughly twice the rate of income growth over that span.

In the meantime, services inflation ex-energy rose by three percent. Think haircuts, lawyers, and healthcare. And yes, in that order. Just call these life’s little non-negotiables whose costs have skipped into the stratosphere.

Finally, there’s that special inflation reserved for those poor folks with smart kids. In the 1970s and 1980s, college costs were rising slower than that of other goods and services. But starting in the 1990s, these costs surged past other costs putting the growth of the cost of tuition alone about six percentage points ahead of headline inflation. Higher education inflation has been galloping ahead of headline inflation. Tuition alone has been rising six percentage points more than headline inflation

The single most encouraging news item that’s crossed the wires of late is that kids who endeavor to pursue a degree in science, technology, engineering and math can expect to make just about as much upon matriculating from an Ivy League school as from a solid state university. The prestigious path leaves next year’s graduate buried in student debt; the other, a reasonable shot at starting a family and settling down before they start to gray.

A question for the ages is whether there are more realistic ways to measure inflation? The Federal Reserve’s preferred measure is a price index based on core personal consumption expenditures (PCE), which also strips out food and energy. The December read on the measure was 1.4 percent. Today’s CPI release indicates the core PCE will tick up to 1.5 percent when it is next reported, a level that remains below the Fed’s stated goal of two percent.

It’s critical to note that over the last year, the divide between core PCE and core CPI has been unusually wide. In fact, the December divide between the two of 0.7 percent is the widest since the recession ended in the summer of 2009. The main culprit in how they differ comes down to their respective calculations for healthcare costs. While the CPI uses what we actually spend, the PCE inputs Congressionally dictated costs for Medicare and Medicare, i.e. fantasy figures. The icing on the cake is that the PCE understates housing vis-à-vis the CPI.

This takes us to market-based measures of inflation expectations. When you subtract the yield on an instrument which adjusts for inflation, such as Treasury Inflation-Protected Securities, or TIPS, from a security that does not, a Treasury note, you arrive at what the market is pricing in as the expected rate of inflation at some point in the future.

The latest figures put 5-year expectations at about one percent and 10-year expectations at about 1.25 percent, the lowest on records dating back to 2003. Suffice it to say the market is pricing in a slowdown as these rates are at the lowest on record in data going back to 2003; they’re signaling the economy is headed into recession.

James Bullard, the St. Louis Fed’s President, remarked earlier this week that market gauges had fallen “too far for comfort.” In typical understated FedSpeak, he added that it was, “unwise to continue a normalization (rate hiking in layman’s terms) strategy in an environment of declining market-based inflation expectations.”

A separate prism into market pricing of future interest rate hikes is validating the grim forecast. Bank loan mutual funds are variable-rate investments whose income increases as economic growth and inflation expectations rise. In a normal world, a rising rate environment coincides with companies’ increased capacity to service their debts.

Given all of the options to gauge investors’ expectations for rising inflation, loan fund flows would seem to pass the logic test nicely. The fact that these funds have bled outflows for 30 consecutive weeks speaks volumes. In the latest week, investors cashed out $645 million taking the total to $17 billion.

The bottom line is the markets are pricing in a steep slowdown in economic growth while the true costs of living continue to outpace income growth. Talk about a challenging set of circumstances for working Americans.

And yet we heard from San Francisco Fed President John Williams just yesterday that, “The U.S. economy is actually doing fine.” Do his views matter? You make that call. He was Janet Yellen’s first lieutenant when she preceded him at his current post.

Williams went on to say that the steep increase in rents reflects the nation’s economic strength. It’s safe to say he didn’t get the memo on 82 percent of apartments constructed in the two years to 2014 being luxury units. Or maybe he’s fully aware and thinks $3,500 monthly rentals such as those in his own backyard are a sign of strength to the average working Joe.

William’s conclusion: “If we look at domestic demand in isolation, it shows strong growth. We’re just contending with outside forces.”

Try telling that to the millions of Americans who don’t quite feel like they’ve been invited to the “strong growth” party. What these folks really need is a realistic game plan that helps them grow the actual size of their pie as opposed to cutting the pie they’ve got into smaller and smaller slices just to get by. What they get are lectures that the cost of living increases they know represent ‘screwflation’ are a figment of their imagination.

The irony is that if the Fed would own up to the true inflation that’s out there, they’d be forced to continue increasing interest rates at the worst possible time. Monetary policy has clearly hit its outer limits and has arguably done more harm than good, once again.

The true responsibility lies with the other policymakers in Washington, the ones elected to shepherd their constituents’ best interests. In the event they need some ideas, three come to mind, starting with educating our youth to excel in a fully globalized 21st Century economy. After that, they should take up freeing businesses to do business at home rather than flee our shores. As a grand fiscal finale, how about upgrading our third world infrastructure. Until strong leaders emerge determined to uphold the basic tenets of democracy and capitalism, the American dream will continue to drift from view.