Mutual Fund Research Newsletter
Copyright 2010 Tom Madell, PhD, Publisher
Jan 2011 Published: Dec 31, 2010

2011 Inflation Challenge

by Steve Shefler

Looking ahead to 2011, it appears likely that the inflation rate could climb as high as 3% on a year over year basis, but there are substantial uncertainties. If the rate were to climb to 3% from this year’s 0% rate, it would be the largest yearly increase since 1978 when inflation concerns dominated the economic headlines. To understand the inflation prospects, it is useful to look at some of the key components of the index: housing, food, clothing and automobiles.

Housing Rent: This is by far the largest component of the inflation index and accounts for 31% of the total. The two subcomponents are: (1) “Owners Equivalent Rent (OER),” the rent that the Bureau of Labor Statistics (BLS) estimates a homeowner would have to pay in rent if they were renting their home. The OER is currently 25% of the inflation index; (2) Rents paid by renters to landlords accounts for 6% of the index. Rents make up approximately 40% of the core inflation index which excludes increases in food and energy prices.

The two questions/inputs used to determine the OER are set forth in the BLS site: (1) To owners: “If someone were to rent your home today, how much do you think it would rent for unfurnished without utilities?” (2) To renters: “What is the rental charge for this unit including any extra charges for garage and parking?” The speculative nature of the OER is particularly acute in the present housing environment where an unusually large number of homes are underwater, in foreclosure or vacant. In such an environment, the owners’ responses may be no more than a wild guess. The OER is further complicated by the fact that most of the renters questioned live in apartment complexes not in single family homes.

In the latest report of the BLS issued in November, there was a 0% increase in the OER on a year over year basis, and a .3% increase in the rents paid component. In the decade prior to the housing boom both actual rents and OER increased by an average of 3% per year.

There are several reports suggesting that the rents paid will accelerate over the coming year. Lawrence Yun, the Chief Economist at the National Association of Realtors has predicted that rents will climb 1% to 2% in 2011. Data collected by Reis, a widely followed surveyor of apartment rents, suggests that the increase could be even greater. Their survey found that rents increased by .7% in the 2nd quarter (2.8% annualized) and .6% in the third quarter, more than twice as fast as indicated in the government’s inflation report. Less followed Axiometrics reported a 5% increase in apartment rents over the past year. The apartment tightness index issued in November by the National Multi Housing Council (NMHC) is running at 73 which is a high level in its 11 year history. It compares with the highest levels which were reached in 2006. Most owners reported higher occupancy and rents. Sixty percent of respondents said markets were tighter, meaning lower vacancies and/or higher rents.

Increased jobs even at a somewhat subdued level of 150,000 to 200,000 per month are likely to have a disproportionately positive impact on rentals. As young people land steady jobs, they will move from their homes or shared living arrangements into their own units.

Put this altogether and it seems highly likely that the OER and paid rents components of the inflation index will climb back toward their prior 3% level but uncertainty clouds the picture, especially with respect to OER

Food: Food prices have climbed 1.4% year over year according to the latest inflation report by the Bureau of Labor Statistics, the lowest annual increase since 1992. Recently food prices have been accelerating. The Department of Agriculture’s economics’ division predicts that food prices will increase by 2% to 3% in 2011. Some economists believe that prediction is too cautious. Michael Swanson, Wells Fargo’s agricultural economist predicts at least 4% food inflation next year.

Higher commodity prices are pushing up food prices across the board. The commodity index is now near its all time high reached in 2008. That year’s commodity bubble resulted in 5.5% food price inflation. A number of factors are again pushing prices higher. First, as the world's economy has started to recover in recent months, the demand for grains such as corn, wheat and soybeans has risen. Farmers are now exporting more grain internationally, while at the same time, demand in the United States has climbed, too. Second, because there's more demand for grain, farmers who raise livestock — both for meat and dairy — are being forced to pay more to feed their herds. And third, fuel prices are up, making it more expensive to deliver products.

Major corporations at each step along the food delivery system have indicated that they will increase their prices next year. Kraft, Sara Lee, Nestles and General Mills already have said they'll raise prices on certain items. Grocery chains Safeway and Kroger have said they'll pass supplier increases along to consumers. The combination of companies wanting to maintain or increase their profits and a slowly growing economy could lead to an acceleration of price increases. While a return to the 5.5% range of 2008 is unlikely, a 3% to 4% pickup is quite plausible.

Clothing and Automobiles: The same commodity price impacts are likely to push up prices in these categories. According to a recent report in Bloomberg, Gap, Penney’s, Wal-Mart and other U.S. retailers may have to pay Chinese suppliers as much as 30 percent more for clothes as surging cotton prices boost costs. Cotton prices have increased up 70% over the past year.

Some wholesalers such as Levi have already increased their prices. Others such as Northface, Hanes and Playtex indicate that they will do so in 2011. The New York Times recently quoted Wesley R. Card, president and chief executive of the Jones Group, the company behind Anne Klein, Nine West and other brands: “It’s really a no-choice situation, prices have to come up.” While retailer may be reluctant to raise prices in a slow growth/highly competitive environment, cost pressures may leave them no choice.

The automobile picture is the same. Steel prices have been steadily increasing over the past year. An executive of GM’s international division recently stated that GM is experiencing, “huge input price pressures with some components up 5% to 15%.”

The year ahead: Based on the above data, it appears that the Federal Reserve and major financial institutions such as Goldman Sachs or PIMCO are underestimating the inflation risk going forward. Even modest GDP growth in the range of 2% to 3% seems likely to result in higher inflation than is now input into most economic forecasts.