Inflation – The Good & Bad

  • Inflation The Good & The Bad
  • What’s Driving Rates?
  • Tailwind For Bonds
  • Market & Sector Analysis
  • 401k Plan Manager

The Good & Bad Types Of Inflation

Since the November election of Donald Trump, the investing landscape has gone through a dramatic change of expectations with respect to economic growth, market valuations and particularly inflation. It is the view of inflation that I want to touch on today as it relates to the belief the “Death Of Great Bond Bull Market” has finally arrived.

The chart below shows the massive surge in inflationary expectations as of late in both the 5-year and 10-year rates as well as the mean PCE inflation rate. (#SarcasmAlert)

As you can see, while expectations of a rise in inflationary pressures have risen since the election, the consumer price index (CPI) was already rising fairly strongly since the beginning of 2015.

So, if the rise in inflation expectations remains muted, what’s the reason for the recent surge CPI? That rise can be directly linked to the full onset of the Affordable Health Care Act which sent medical inflation costs surging. This is something I warned about many times in the past.

The impact of the Affordable Care Act is now taking root. Unfortunately, for many, that impact is not a positive one as surging premiums absorb more of the discretionary budget of households.”

The Fed believes the rise in inflationary pressures is directly related to an increase in economic strength. However, as I will explain: Inflation can be both good and bad.

Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices.

That would be the good.

The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.

If we take a look at import and export prices there is little indication that inflationary pressures are present. 

This lack of economic acceleration can be seen in the breakdown of the Consumer Price Index below. It can clearly be seen where inflationary pressures have risen over the last 5-months.

(Thank you to Doug Short for help with the design)

As is clearly evident, the surge in “health care” related costs, due to the surging premiums of insurance due to the “Un-affordable Care Act,” pushed both consumer-related spending measures and inflationary pressures higher. Unfortunately, higher health care premiums do not provide a boost to production but drain consumptive spending capabilities.  Housing costs, a very large portion of overall CPI, is also boosting inflationary pressures. But like “health care” costs, rising housing costs and rental rates also suppress consumptive spending ability.

For the middle-class and working poor, which is roughly 80% of households, rent, energy, medical and food comprise 80-90% of the aggregate consumption basket.” – Research Affiliates

The problem for the Fed is that by pushing interest rates higher, under the belief there is a broad increase in inflation, the suppression of demand will only be exacerbated as the costs of variable rate interest payments also rise.

With households already ramping up debt just to make ends meet, another increased expense will only serve to further suppress “consumer demand.” 

The Rest Of The Story

As Michael Lebowitz noted:

By narrowly focusing on consumption, economists have lost sight of production. Such disregard for the supply curve is proving to be a costly error.

As monetary policy increasingly encouraged debt-financed consumption, corporations responded by expanding their capacity and operations to keep up with the policy-induced demand for their goods. Both the demand and supply curves shifted in unison, reflecting greater demand and production capacity. Unfortunately, over time, the consumers’ ability to take on additional debt has diminished and the demand curve shifted back. The supply curve, however, is less flexible as corporations cannot easily reduce their production capacity. Attesting to this overbuild is capacity utilization which, as graphed below, is trending lower and stands at a level that has been indicative of recessions in prior cycles.

 Capacity Utilization


Data Courtesy: St. Louis Federal Reserve (FRED)

In response to weaker demand, corporations downsized employment, outsourced production and limited wage increases. Partially as a result of their actions, the labor participation rate lingers at 38 year lows and real median wages are at levels comparable to 1998. Corporations created a negative economic feedback loop as their employees are also consumers of their products.

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Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Streettalk Advisors, LLC expressly disclaims all liability in ...

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