Inflation: Momentum or Reversion to the Mean

With headline inflation at multi-decade highs investors are rightly concerned and it bears an in-depth look. Some of the drivers of price rises have persisted longer than the Fed expected. But looking beyond the headlines at some of those drivers of the last twelve months could be useful.

The biggest inflation bogeyman over the past year has been energy prices where the CPI component notched up a 27% rise in the 12-months to January. Gasoline is the largest component in energy and up the most so a historical perspective is instructive. The national average gas price started the year 20% below the 15-year average and after a peak in November eased until geopolitical conditions pushed it back up to 23% above that average.  Most of that movement (40%) was in the first seven months of 2021 and it has only added another 10% since the end of July. The current price is in the 83rd percentile of prices over the last 15 years. For this component to have a similar impact in the next 12-months the current price would need to rise another 40% to over $5/gallon, or 21% higher than any time in the last 15 years. That does not seem achievable, even if there is some geopolitical disruption.

Consumers also have felt considerable pain at the meat counter and in the entrée prices at their favorite restaurant. Beef prices are up 16% in the year to January, pork is up 14%, with chicken up 10%.  Beef is the largest component of the category and is up the most. Due to plant shutdowns in 2020 the number of cattle processed in the U.S. fell -3%, while exports rose 7% and imports fell -13%. This left processed inventory down -9% at the end of the year. Production headcount and imports have both recovered to pre-covid pace. Using average hamburger prices as a benchmark there has been a clear rising trend over the last 20 years. At the beginning of 2021 prices were -7% below the trend line and as of October +8% above, in the 82nd percentile of that comparison. They have fallen -3.5% from the peak. A repeat rise of 16% would put the price of hamburger 17% above the trend line, or in the 92nd percentile. While too early to declare persistently falling prices a repeat of double-digit meat inflation does not seem likely.

The largest sub-component of CPI is shelter, which is largely owners’ equivalent rent at 24% of the total. See Exhibit #1 for a breakdown of CPI components.  This input is only up 4.1% over the past year and an annualized rate of increase is 4.9% over the last 3 months, slower than the 5.7% in the previous 3 months. Rents are up a similar amount. Because shelter is such a large wallet share of consumer expenditures if it continues to escalate inflation could be more persistent. Admittedly, this component is very volatile. Spikes in the growth rate are fairly common. But extended periods of sustained high price increases are rare. In the last 25 years, the annualized 3-month average increase has been above 4% seven times and stayed there an average of 3.7 months. After the peak, it returned to below 3% on average within 6 months. Currently, this rate has already been above 4% for 5 months. Will history repeat?

Wages are on the rise as businesses compete for qualified workers. The most direct impact is in the service sector, which makes up about 25% of the CPI excluding shelter and energy services. There is still a lot of noise in the headline wage numbers so we looked at some indicative groups. The first is non-supervisory leisure and hospitality workers whose average weekly earnings have jumped 19% in 2021. But they are only 13% above pre-Covid levels, which works out to be about a 7.3% annual rate. Likely higher wages reflect the difficulty in hiring, but also some make up for lost wage increases in 2020. Retail hourly workers similarly are enjoying weekly earnings about 13% above pre-Covid levels, but the rise was more evenly distributed between 2020 and 2021. If the employment pool begins to normalize this catch-up period could give way to the 3-3.5% gains in the previous five years.

The supply chain has also garnered much attention. Shortages and shipping costs are impacting businesses that rely on ships, trucks, trains, or offshore suppliers to help them offer goods for sale. But the portion of CPI that could be impacted by logistics only totals about 12% of the index. Some of these bottlenecks take time to get worked out. But it appears there is already progress being made. First-quarter goods imports were 5.2% higher than the same quarter in 2019, the second quarter was 6.2% higher, the third quarter was 6.7% higher, and the fourth quarter was 14.1% higher. Incremental improvement indicates steps are being taken to address the situation.

While the media focus has been on the trailing 12-month price rise, the one month change in CPI peaked in October at 0.9% and has since eased to 0.6%. It could be that high prices are beginning to help cure high inflation. In the most recent University of Michigan consumer survey the conditions for buying a vehicle series were the second lowest of all time, only eclipsed by the November 1974 reading, and conditions for buying large household durables were at an all-time low. With such consumer pessimism it might not take much tightening to see lower demand.

None of this is intended to imply that inflation is not a risk. It most certainly is and should be taken seriously. The point is really that persistently higher inflation is not the foregone conclusion that some would have you believe. Is momentum the key element in the future direction of inflation or is reversion to the mean? Human nature is to focus on the former when the latter is often a much stronger force.

Rick C. Villars, CFA, is a global investment strategist with Smith Group Asset Management.
Smith Group Asset Management is an Associate member of TEXPERSThe views and opinions contained herein are those of the author and do not necessarily represent the views of Smith Group Asset Management or TEXPERS. These views are subject to change.
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