Why US inflation might surprisingly fall
3rd September 2018
In a recent post on this website, one of my colleagues made the very reasonable assertion that the largest component of the U.S. Consumer Price Index (CPI), which is Owner’s Equivalent Rent (OER), might be complicating the overall index due to the inherently imprecise measurement of imputed housing costs. Given how much importance policymakers place on the trend, and the absolute level of inflation as evidence to lift policy rates, it might be worthwhile to explore a few reasons why some important components of CPI may be pointing to lower inflation in the months ahead.
Input cost increases from wages and tariffs may not be fully passed on to consumers
The vast majority of U.S. corporations operate in global markets where the clearing prices for goods and services are set independent of any single company, and where substitution with other similar goods is always a possibility. Given that many items in the CPI core goods basket are manufactured outside the U.S. (including apparel, household furnishings, recreational goods, furniture, and computers), we are doubtful of a direct linear link between U.S. wage inflation and prices.
Regarding wage inflation, millions of U.S. employees benefited from pay increases at the end of 2017, either through one-time bonuses or through minimum wage increases that occurred in 18 states. However, corporations have been able to blunt the effects of these higher compensation costs due to the massive Trump corporate tax cuts, and elevated profit margins that remain near all-time highs (as a percentage of revenues).
On tariffs, while the Trump administration has threatened to place tariffs of 10% to 25% onto $200 billion of Chinese goods, this accounts for less than 1% of world trade. Thus these tariffs are expected to have only a very modest, one-time inflation impact. In fact, if the world’s superpowers were to engage in trade protectionism to any extent, the impact may very well be deflationary over the medium term, if it results in weaker global growth and slower wage growth. Citigroup recently estimated that the current round of tariffs would add less than 0.1% to inflation, and that this 0.1% is before considering the effects of substitution, improved productivity, tariff redistribution to other companies, and the prospect that companies absorb these costs in order to maintain market share.
An actual recent example is Harley-Davidson, which recently stated that while steel and retaliatory tariffs on importing motorcycles into the EU would cost the company $100m annually, the company would not raise motorcycle prices for customers. Instead, the company will adapt in the medium term by shifting its European motorcycle production out of the United States to a different and lower-cost jurisdiction.
Rising mortgage rates and tax code changes are only starting to impact housing affordability, which should have a negative impact on rents going forward
Given the substantial increases in the 30-year national mortgage rate from 3.32% to 4.47% since Q3 2016, a new buyer can now afford to borrow about 10% less than two years ago. Morgan Stanley estimated that monthly mortgage payments as a percentage of income are at their highest levels since 2008, adjusted for housing prices. In addition, changes to tax deductibility that make home ownership less desirable should also negatively impact prices for both rental and owner-occupied homes.
Shelter inflation will overstate housing costs in a slowing market
While tenant rent inflation is directly observable, the Bureau of Labor Statistics applies statistical estimation methods to impute ”rent” on owner-occupied houses (Owner’s Equivalent Rent). According to the New York Fed in a paper published in 2010, it found that the statistical methods employed by the BLS have the effect of smoothing shelter inflation for owner’s equivalent rent relative to tenant rent inflation, and also to overstate OER in periods of slowing housing inflation. This goes with the well-known observation that shelter inflation tends to lag home prices by 18 months, so any observed drop in shelter inflation will only slowly filter into the OER calculation over the coming quarters.
As for tenant rent inflation, the calculation for rental rates is not based only on new lease contracts that reset during the month, but the average of all rents during the month, which tends to dampen any (downward) changes in rents. Rents also tend to exhibit “price stickiness” where rates move up easily, but move down only with difficulty, partly due to friction costs of switching and moving.
Factors affecting certain components dragging inflation higher are unlikely to be repeated
Price effects from the mid-2017 hurricanes in the southern United States continue to exert measurable upward pressure on inflation. Hurricane Harvey in August 2017 destroyed approximately one million cars in the southern United States, and forced many people from their homes. As a result, there was a noticeable uplift in both shelter inflation and used car prices in the South region following the hurricanes, as well as an uplift to the national average cost of insurance (7.6%) and to the price of leased cars (5.7%). So despite being a small weighting of 6% in the basket, transportation services contributed an outsized 0.22% to CPI in June.
The observed 24% year-over-year rise in fuel costs, mostly due to higher oil prices, is of course excluded from the calculation of core inflation, but still exerts a real cost to the economy. The cost is due to elevated embedded transportation costs for basically all other goods in the CPI basket, and as a result we would expect goods inflation to trend lower if oil prices stabilise from current levels.
Morgan Stanley recently calculated that the cumulative effect of these base effects will present a drag on headline CPI of around 100 bps over the next six months. Given that headline CPI is running at 2.9%, this would bring the headline trend number comfortably close to the Fed’s 2% inflation target, and markedly lower than the 2.4% core inflation being reported. All told, we are not fearful of a pickup of core inflation, whose trend seems to have faltered and whose underlying trend is firmly anchored near 2%.