Inflation – The Big Three: Housing, Transport and Food

Inflation is increasingly the focus of business media and investment analysis. Where is it going over the next year? The three biggest components of the inflation index, housing, transport and food, make up 73% of the consumer price index (CPI). Examining the trends in these areas provides some important clues about what to expect from inflation overall.

Housing

Housing makes up 41% of the CPI and is by far the index’s largest component. 25% of the CPI is for “owners’ equivalent rent (OER),” the amount the Bureau of Labor Statistics calculates that a home owner would have to pay in rent if they were renting their residence. 5% is for rents that individuals actually pay to landlords. The remaining11% is for fuel, furnishing and utilities.

Both the OER and rentals indexes rely on data collected from actual renters, and they have closely tracked each other since the inception of the OER in 1981. The most recent CPI report issued in May 2011 for the April results indicated that over the prior year the OER has risen 0.9% while actual rents have risen by 1.3%.

Private surveys of the rental market project significant rental increases over the next two years. Reis, the mostly widely reported survey of the apartment market, projects a 4.3% rental increase this year and an increase of the same magnitude next year. MPF research and Axiometrics project a 5% increase this year. These projections are based on falling vacancy rates due to modest increases in overall employment, and household formation. While there has been an increase in demand, due to the recession far fewer apartment units were constructed in the past three years than would ordinarily be the case. So if employment picks up at a more rapid rate, say 350,000 new jobs per month, the projected rents would likely rise even faster than currently projected.

Since the rental-based components of the CPI support such a large percentage of the whole, an increase at a rate projected by the private surveys would drive both headline and core CPI significantly higher. The private survey projections are consistent with a 400% plus increase in the rental components of the CPI from their current approximate 1% level to 4% or greater level. There has been little media coverage of the projected increases in housing rentals. Most reporting has ignored the shelter component of the CPI, even though it is by far the largest component. However, Morgan Stanley’s economic team shares the view that rising rents pose a serious threat to inflation going forward.

Transportation

17% of the CPI is for transportation costs. The largest subcomponent is for the price of new and used cars, which is 7% of the CPI. Gasoline accounts for 5%. The remainder is for auto parts, maintenance, public transport and tolls.

Gasoline price grabs the headlines, even though it comprises only 5% of the index. The consensus among economists is that gas prices are unlikely to increase much further in the coming year. The year over year increase in the April CPI report for gasoline was 33%, making it the biggest contributor to an increasing CPI in that time frame. If gas prices remain steady or decline slightly, however, they will not contribute to a growing CPI going forward and may reduce the rate somewhat.

The prospective price picture for new and used vehicles is likely to place upward pressure on the CPI index, due in large part to increased demand from consumers who put off replacing aging vehicles during the recession. Wholesale used vehicle prices on a seasonally adjusted basis rose 1.9% in April and pushed the Manheim Used Vehicle Value Index to a record high of 126.6. Over the past year, adjusted wholesale prices for used cars have risen 4.9%. Reduced car production during the recession has brought the inventory of late model used cars to abnormally low levels.

The price picture for new cars is also likely to be challenging. According to a May article in USAToday:

Be prepared to pay significantly more if you need a new car in the next few months -- and probably longer -- warn reports from auto research and information sites Edmunds.com and TrueCar.com today. Almost every major carmaker has raised sticker prices in the past few months to cover higher commodity costs (which still are rising), and now comes news from Edmunds.com that carmakers have cut sales incentives in April to the lowest level since the site started tracking them in 2005.

Both Edmunds and TrueCar, the preeminent new car price analysts, suggest that an increase in the 5% range over the coming year is likely. The sharp increases in commodity prices, especially in metals, will also likely increase the cost of auto parts and maintenance over the coming year.

Food

15% of the CPI covers food costs. Each month the economics division of the United States Department of Agriculture puts out a report projecting the CPI component for food costs. The report issued in late May indicates that the CPI for all food is projected to increase 3 to 4% over the next year. Food-at-home (grocery store) prices are forecast to rise 3.5 to 4.5%, while food-away-from-home (restaurant) prices are forecast to increase 3 to 4%. By contrast, the all food CPI increased 0.8% between 2009 and 2010, the lowest number since 1962.

A number of prominent food economists such as Bill Lapp, Former Chief Economist at ConAgra, and Michael Swanson of Wells Fargo, have predicted that food prices will climb higher than the Department of Agriculture has projected, more likely in the 4.5 to 5.5% range. One key issue is the ability of grocery stores, food producers and restaurants to pass along the sharp increases in food commodities prices to their customers. While major purveyors such as McDonalds and Starbucks have increased prices, they have not yet passed on a substantial portion of the increased commodity prices they have been forced to pay.

Implications For the Investor

The takeaway is that the inflation index is likely to rise in the 4% range over the coming year. It is far from certain what the Fed will do with interest rates if this projected scenario plays out. The Federal funds rate is now effectively zero. Yet year over year inflation is now running at the same level (3.2% in the last report) it was when the Federal Funds rate was at 5.5%. It is important to keep a long term perspective. In the past 20 years, the CPI has exceeded 4% on only one occasion - 2008. In that year a spike in oil prices occurred, the full year rate was 4.1%. On an additional five occasions, it was between 3% and 4%. For the remaining fourteen years, it was less than 3% per annum. Inflation expectations and changes move markets and should be closely watched by the prudent investor.

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