At first glance, the August CPI report, versus the raging fever of the past few months, doesn’t look catastrophic. The headline reading of 8.3% showed a slight increase of 0.1%, along with a similar drop for July, which held prices steady for two months. This is a significant turnaround from the hyper-trend for the first half of 2022, the period in which the CPI was rising at an average of 1% per month, or 12% segment per year. But the CPI that continued to trend sideways was not the jubilant news that investors had been expecting. The July data had fueled optimism that the Fed’s rate hike was already taming the beast, that the peak had passed, and that consumer prices would drop significantly in August, sending the US on a slide toward the Fed’s 2% target and creating space for the bank central mitigation. When the September 13th data disappointed, Wall Street bulls pulled back, sending stocks into their sharpest one-day sell-off in more than two years.
In fact, the forecast for the coming months worst From August figures that “no increase” and that greatly disturbed investors. Going forward, we are likely to see CPI return to the pattern of serial increases. the reason? Housing costs, the biggest force of all in moving the CPI, are already rapidly raising Americans’ living expenses. But due to the way it is measured, a large part of these increases in the index have not yet been accounted for. “This component is growing and will continue to grow,” says Campbell Harvey, professor of finance at Duke University. Inflation has already occurred, but it has not yet been reflected in the consumer price index. This is part of the reason why inflation will rise in the future and will continue. The view that the story is only about supply chain and political risk, and that we will quickly go back to 2% or 3%, is misleading.”
The CPI methodology makes it very likely that the number will remain high in the coming months
Harvey distinguishes between two factors that will determine future CPI readings. The first is what he calls “mechanics,” or how the CPI is calculated. These levers pretty much set the numbers for the next few months, and it’s not pretty. The second factor is “structural” factors that are dominated by the rising tide of housing costs and rents that will increasingly inflate readings over a longer horizon.
In terms of mechanics, Harvey explains that the change in annual inflation depends on two things: the size of the monthly increase 12 months ago, and the rise in the current month. When the increase in the current month is less than that of the previous year, the annual CPI “monitoring” should decrease. This explains the dramatic drop in July, which sparked high hopes. Prices rose by as little as 0.1%, and since the rise in July 2021 was much larger at 0.48%, the index fell dramatically from 9.1% in June to 8.5%. Similarly, in August, the 0.1% increase was less than the 0.30% increase in August of 2021, resulting in a smaller decline to 8.3%. Simply put, the higher the month-over-month increase, the more the CPI will fall if the current month is flat. Those mechanisms explain the decline from 9.1% to 8.3% from June to August.
But 8.3% is still a huge and worrying number. So what do mechanics tell us about the direction of the CPI in September, the last reading before the November elections? Let’s assume the hoped-for assumption that inflation is running at an annualized rate of 3% in September. This would add 0.25% to prices during the month of August. Since the increase in September 2021 was almost identical at 0.27%, inflation will remain exactly the same at this alarming figure of 8.2%. Using the most optimistic forecast that prices will hold steady at August levels into September, the figure is not much better at 8.0%. Bad readings remain for months to come. If prices rose at that 3% annual rate through December, the CPI for that month would be 7.6%, nearly four times the Fed’s target.
Housing costs will keep inflation high for a long time
The Bureau of Labor Statistics’ methodology for measuring housing costs explains why they are not fully featured in the current index, and will keep them high for a long time. ‘Shelter’ carries by far the most weight in the CPI at 32%, and thus dwarfs second with food ranking second at 13%. The BLS uses two metrics to calculate “shelter,” based on surveys of 50,000 dwellings. The first is “basic housing rent”. It’s what residents or renters of single family homes pay now, in the month that is being measured. For homeowners, the BLS doesn’t use home prices, which have dwindled about 20% overall in the past year. Instead, it publishes “owner equivalent rents.” To get these numbers, the BLS takes what renters now pay for apartments, and adjusts those payments by size, age, renovations and neighborhoods to calculate what the owners will pay to rent their dwellings. In fact, the growing institutional single-family home rental market is a good measure of these calculations.
This methodology accounts for the significant difference between what people are now paying on their existing apartment leases, or a hypothetical lease on a single-family home, and what a household is now paying for a new lease—in other words, the current and real value—the cost of housing time. Over the past year, the Zillow rent index has shown double-digit increases. As of August, the year-over-year number was 12.3%. Early this year, increases in the cost of housing in the CPI were 3% and 4% annually. In August, the figure was around 7%. “This is the difference between today’s housing costs and the CPI number,” Harvey explains. “If you sign a 12-month lease in October of 2021, your rent will be closed through October. New rents go up in double digits, but you don’t pay the extra costs. Then you get a new lease in October, and your rent jumps, say, 10% You suffer those blows all at once.” Harvey says that these gradual increases, as more and more leases are renewed with much higher rents, will close the gap between current CPI numbers and much higher rents in the market, pushing the index higher.
A combination of rising rents and food prices will keep inflation steady
Housing costs are going down somewhat. In recent months, Zillow’s increases have approached about 10%. However, this is well above the 7% reported by the CPI in the past two months. At a third of the index, a 10% increase in “rents” equates to a 3% annual rise in the CPI, and for Harvey, frequent internal increases of this magnitude are likely to persist for up to a year. But the problem is that energy, the famous force that has kept the CPI generally flat for the past few months, is unlikely to make the same contribution to shattering the index in the future. “Gasoline accounts for only 5% of the index, but it is roughly the same as the slightly negative overall reading in July and August,” Harvey says. In August alone, gas was down 10.2%. “I don’t see that we will get the same weight as the collapse in the price of gas again,” he adds.
On the other hand, food prices rose at an annual rate of nearly 10% in August, on top of a 13% jump in July. “I don’t see any indication that the rise in food prices is abating,” says Harvey. “The index may start to rise again, unless we see another sharp drop in energy prices.” By mid-2023, Harvey predicts inflation will remain well above the Fed’s comfort level, at more than 4%. The main factor likely to keep CPI high is catching up in unaccounted housing costs. This is the spoiler that lost the optimists.
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