Inflation has remained elusive over the past few years, often teasing the Federal Reserve and economists with encouraging figures over several months, then disappointing them months later. Inflation was close to zero in 2015, but rose above the 1 percent barrier in early 2016 (thanks to the recovery in energy prices), eventually reaching 2 percent by the end of the year. Consumer prices more or less rose close to the 2 percent rate across 2017, ending the year at 2.11 percent, barely unchanged from the 2.07 rate at the end of 2016.
Despite headline inflation seemingly remaining steady over the year, there were significant changes below the surface. In this piece, we look at how the various sub-components of inflation – which contributed and which dragged – giving us an idea of what is likely to persist.
Exhibit 1. Consumer price index of major categories and select sub-categories, author calculations. Source: Bureau of Labor Statistics
The biggest story here is rising food prices. Food and beverages dragged on aggregate headline inflation in 2016 by 0.02 percentage points. By 2017, food and beverages added 0.23 percentage points, a difference of 0.25 points – the highest of all of the major categories.
Next is the continuing recovery in energy prices. Transportation, which includes new and used autos, airline fares, and motor fuel (among others) contributed 0.53 percentage points in 2017, up from 0.38 percentage points in 2016. Among the three sub-categories chosen for analysis, motor fuel rose the most over the years’ time, contributing 0.07 percentage points more in 2017 than it did in 2016. New and used autos, which is also a sub-category of transportation, saw prices stabilize over the year, improving 0.05 percentage points. Despite the improvement, however, auto prices were still a drag to aggregate inflation in 2017, subtracting 0.02 percentage points.
Prices for recreation activities (televisions, toys, and pets, for example) also rose over the year, although at a much slower pace than the other two categories. The category contributed 0.09 percentage points in 2017 compared to 0.04 percentage points in the previous year.
One of the more significant changes in consumer prices originated in the housing sector, especially when you exclude energy. Housing, which contributed 1.28 percentage points to aggregate inflation in 2016 (typically the highest weighted category of the eight) fell by 0.07 percentage points in 2017. A large portion of the drag came from household furnishings and operations, contributing 0.13 percentage points less in 2017. Household energy, which is a sub-category of housing did rise to over a years’ time, increasing by 0.04 percentage points, but more on that later. The housing market is important to the aggregate economy as it contributes a rather significant portion to overall GDP.
The largest differential was in medical care. In 2016, medical care contributed 0.34 percentage points compared to 0.13 percent in 2017, a decline of 0.19 percentage points. Prescription drug prices, which is a sub-category of medical care, contributed 0.5 percentage points less in 2017. This development was rather surprising, and perhaps welcome, as prescription drug prices are rather hot-button issue for the White House at the moment.
Education and communication, which groups together educational books and supplies with personal computers and telecommunication, is another category that has seen prices decline over the course of a year. Dragging 0.02 percentage points on aggregate inflation in 2016, prices continued to deteriorate, with education and communication subtracting 0.12 percentage points in 2017. Wireless services prices, which the Federal Reserve determined to be transitory declines, has yet to recover, dragging down inflation by 0.18 percentage points in 2017(versus 0.08 percentage points in 2016).
Headline and core inflation
When looking closely at headline inflation, there are a few positive indicators but mostly worries. The two most improved categories are food and beverages and transportation (which capture essential consumer, non-discretionary consumer price changes), increased by double-digits over the year.
However, the recovery of food and energy prices may only be transitory in the short-term, which may not be indicative of rising inflation in the future at all. Many prefer omitting these prices, as they often fluctuate quickly. Take for example motor fuel. Gasoline prices often fluctuate day by day (notice the price differences during morning and evening commutes each day), and spikes in prices can be unpredictable. Food prices are also volatile, as natural weather events can create price surges depending on the severity. In addition, the increase in home energy prices may also be transitory, as prices can fluctuate due to cooler than normal temperatures or various natural gas shortages due to supply disruptions.
Core inflation, which omits food and energy prices, deteriorated significantly in 2017. In 2016, core inflation was actually higher than headline, at 2.20 percent versus 2.07 percent, respectfully. By 2017, core inflation fell 0.42 percentage points to 1.78 percent, while headline inflation rose to 2.11 percent. The 0.33-point difference between headline and core inflation signals that the more volatile prices are providing the boost, instead of a core base of price increases. As a result, it may be too early to determine that inflation is here to stay.
Outlook for 2018
When looking at the data, we have some concerns regarding the trajectory of core prices as many of them have declined over the previous year. With medical care, education and communication, and housing rounding out the top three biggest decliners over the past year, we are not so certain that these will recover in the short-term.
As previously noted, the White House has stated that cutting drug prices is a “top priority”. In addition, Amazon, Berkshire Hathaway, and JP Morgan also stirred up the health care market, as all three agreed to create their own independent health care company for their employees, and possibly for the general public in the future.
Wireless services prices (a sub-category of education and communication) remain suppressed and will likely remain that way. Comcast Xfinity introduced their own wireless service to consumers in 2017, creating even more competition among Verizon, T-Mobile, Sprint, and AT&T. The increased competition is likely to continue to bring down prices, especially as Comcast said that it plans to accelerate its cellular business in 2018.
The only wild-card of the three biggest decliners is housing prices, which are measured in a rather interesting way by the Bureau of Labor Statistics. As the bureau uses imputed rents instead of housing prices, there is some indication that there may be a rise in 2018. However, others also note the ‘stickiness’ in imputed housing rents and calculating housing inflation in this manner. This means we shouldn’t expect very large movements in a relatively short amount of time for housing inflation.
In short, a lot has to happen in 2018 for a consistent rise in inflation to occur, as much of the boost in headline inflation came from more volatile food and energy prices. The less volatile categories have struggled to keep up and that may continue into 2018 as the qualitative data suggests. Of course, many of these prices could rise if other economic variables assist in pushing up prices, for example wage and productivity growth. However, we have yet to see any supporting data of such optimal increases.
This post is for informational purposes only and is not to be considered a recommendation to buy or sell a security or service. Convex Capital Management LLC (“Convex Capital”) utilizes best efforts to ensure the content displayed herein is from sources believed to be reliable and accurate, but makes no representation thereof and accepts no liability or any loss arising from use or reliance of any of the information herein. The opinions expressed are a reflection of Convex Capital Management’s best judgment at the time this report is compiled, and any obligation to update or alter forward-looking statement as a result of new information, future events, or otherwise is disclaimed. There is no guarantee that Convex Capital has not changed its research views after the blog-post is published.
Convex Capital is a registered investment adviser. Registration does not imply a certain level of skill or training. More information about Convex Capital’s advisory services and fees can be found on its Form ADV which is available upon Request. There is no assurance that any securities, sectors or industries discussed herein were or will be included or excluded from an account’s portfolio.