Every month the Bureau of Labor Statistics publishes the consumer price index (CPI). The headline number is an attempt to show the change in prices for a fixed basket of goods that the average consumer buys. The largest component is housing, technically called shelter. Other components are autos, clothing, healthcare costs, food and energy. Food and energy are considered particularly volatile and less subject to long-term trends; therefore, they are often removed, and “core” inflation is reported without these two components.
For August, headline inflation was up 8.3% year over year (YoY) and core was 6.3% YoY. The headline number continued to trend down, although it was higher than estimates, while the core number was up more than estimates. What about “sticky” inflation? These are goods for which prices can remain stubbornly high because their prices are not adjusted frequently. Examples include children’s clothing, motor vehicle insurance, medical care goods, public transportation and, importantly, rent. These can be contrasted with the price of gas, which can change daily. The Federal Reserve Bank of Atlanta publishes a sticky index, which was up 6.1% in August, and is not trending down.
Sticky inflation is important because once these prices increase, they can take time to reset, which impacts both inflation and inflation expectations. This matters because inflation expectations are nearly as important as actual inflation. Once the expectation for higher prices in the future is embedded in the consumer psyche, consumers will be quicker to pay more now, allowing for further price increases and the potential for an upward spiral.
When Eagle Ridge reviews inflation data, we generally focus on the core number and the cost of shelter. As mentioned, shelter is the largest component of the headline CPI number (about 32%) and part of the sticky basket. Shelter is rightfully the largest component of CPI as the rent or mortgage payment is generally the largest household expense. The shelter number is an aggregate of rent, owner’s estimate of rent (i.e., how much homeowners think they could earn in rent), other lodging such as hotels and home insurance. Once rent goes up, it generally stays up. And if one buys a house in an inflated real estate market, one doesn’t get a refund from the sellers when housing prices fall down the road. Shelter costs took a while to rise in 2021, back when inflation was considered transitory. It began to noticeably increase in the 3rd quarter of 2021.
In addition, Eagle Ridge reviews the change in employee earnings, data reported at the same time as the CPI. Wage growth has fallen behind inflation since April 2021, which is when inflation increased over 4% year over year. The 4% increase was the largest increase since 2008. Since that time, real wages, i.e., wages adjusted for inflation, have fallen by an average of 2% YoY. This is the first-time earnings growth has been slower than inflation for an extended time since 2012, and that gap was less than 2%. In other words, for the first time in a decade, employee earnings are being outpaced by inflation.
What does this mean? The data points to long-term inflationary pressure. While the headline number is trending in the right direction, the sticky numbers are not, and wages are falling in real terms. Investors can expect a determined Federal Reserve, meaning a likely 75 basis points (0.75%) increase in September and little chance of a rate cut in 2023. When picking stocks, inflationary pressures and a higher Fed Funds rate means companies need pricing power (the ability to pass along the higher prices) and reasonable valuations. Eagle Ridge’s investment process consistently looks to identify these characteristics in any investment and will continue to do so. While market volatility will continue, companies are dynamic and will adjust to grow and prosper, even in a longer-term inflationary environment.