FINANCIAL REVIEW

Inflation or the Lack Thereof

Sinclair Noe — October 22, 2014

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DOW – 153 = 16,461
SPX – 14 = 1927
NAS – 36 = 4382
10 YR YLD + .02 = 2.23%
OIL – 2.06 = 80.43
GOLD – 8.40 = 1242.00
SILV – .34 = 17.27

The major stock indices were higher this morning, then they dropped about the time were heard reports of a shooting in Ottawa Canada, near the parliament building. The shooting in the Canadian capital left a soldier dead and the city on lockdown.

The Labor Department said the Consumer Price Index edged up 0.1% last month. In the 12 months through September, the CPI rose 1.7%. The core CPI, which strips out food and energy prices, ticked up 0.1% last month, while the year-on-year change held steady at 1.7%.

Energy prices fell for a third straight month in September, with gasoline costs slipping 1.0% after dropping 4.1% in August. Food prices gained 0.3% in September and were up 3.0% from a year ago, the largest gain in nearly 2-1/2 years. Shelter costs increased 0.3% in September after rising 0.2% in August. The medical care index increased 0.2%, with prices for nonprescription drugs posting a record increase. Airline fares declined for a third straight month, while prices for new motor vehicles and apparel were unchanged. Prices for used cars and trucks fell for the fifth straight month. Wages remain stagnant. Average hourly earnings adjusted for inflation fell 0.2% in September and were up just 0.3% over the past year.

Higher rents are the main reason prices are rising at all. Excluding food, fuel and shelter costs, consumer prices dropped 0.5% at an annualized rate over the past three months. Those costs were up 0.9% over the past 12 months, close to the 0.8% increase in the year ended in February that was the smallest in a decade.

We know the Federal Reserve has a target of 2% inflation. The Fed uses a slightly different report to measure inflation, and their data shows inflation at 1.5%, well below target. The Fed had said last month that quantitative easing would probably end after its next meeting, on Oct. 28-29, and reiterated that rates would remain low for a “considerable time” after the asset purchases program ends. Federal Reserve Bank of St. Louis President James Bullard said last week that the central bank should consider delaying plans to end its bond-buying at the end of this month to halt a decline in inflation expectations. Bullard was probably just trying to talk up the markets, or jawbone; and it seems to have worked. The real question is whether the Fed will continue with QE, or maybe end QE3 and come up with some new stimulus program; after all, inflation is not preventing more stimulus. Indeed, the lack of inflation may be a bigger concern for the Fed.

Deflation can create a trap, but low inflation, or dis-inflation can create the same trap. The idea is that things will cost less tomorrow and so people put off buying, waiting for the lower prices. This also affects employment because there is less demand and fewer sales. Also, it is easier to give raises that are just a little bit less than the inflation rate; that’s like a real wage cut when adjusted for inflation. When inflation is low, the result is fewer new hires and more people laid off. And while inflation is bad for creditors, deflation is horrible for debtors. Prices and wages fall, but debt payments do not. So you’re forced to cut spending. And this cut in spending just increases the downward deflationary spiral.

For many years we were told that inflation was the problem, and it was a big problem…, 40 years ago. There are still some people fretting that, given all the money the Fed has pumped into the economy in quantitative easing, inflation is just around the corner. It might be a problem at some point in the future, but right now the concern is low inflation or deflation.

The CPI is the data that is used to determine Cost of Living Adjustments, or COLA, to Social Security benefits. Millions of older Americans will get a 1.7% increase in their monthly payments next year. The increase amounts to about $20 a month for the typical Social Security recipient. It’s the third year in a row the increase will be less than 2%. The $20 bump in Social Security payments may not sound like much, but it works out to about $240 a year, or about $500 for a married couple. The payments will hit in January.

Congress enacted automatic increases for Social Security beneficiaries in 1975, when inflation was high. For the first 35 years, the COLA was less than 2% only three times. Next year, the COLA will be less than 2% for the fifth time in six years. This year’s increase was 1.5%, the year before it was 1.7%.

The price of oil was down again today. This has been one of the biggest moves in the markets. The Department of Energy says American oil inventories increased by 7.1 million barrels in the week to October 17. Although this was somewhat smaller than the previous week’s 8.9 million-barrel build, it was still much larger than estimates of about 3 million barrels. The key question is whether this steep drop in prices is the result of cyclical factors; such as economic stagnation in Europe, the slowdown in countries such as China and Brazil; or whether it reflects a more fundamental trend.

The US is on its way to becoming energy independent, although it will take another 15 years or so. We are conserving more, thanks to ideas such as better fuel standards for cars, and at the same time we are producing more domestic oil. Next year, the US will become the top global oil producer. Nigeria used to be the fifth largest external supplier of oil to the US, but Nigeria has not exported a single barrel to this country since July. Lower oil prices will hurt some global economies, such as Russia and Iran, but it will help the economies of countries dependent on oil imports, such as Europe, Japan, India, and even the US. Moody’s estimates $1.2 billion in savings for United States consumers for each percentage-point decline in the price of gasoline every year. The drop in fuel will free up as much as $60 billion over the next year that the consumers can spend on other goods and services.

The global economics team at Bank of America Merrill Lynch weighed in with the idea that a 25 dollar drop in US crude oil prices could be good for as much as 40 basis points worth of GDP growth over two years. That’s doesn’t sound like much, until you realize the global economy is bumping along at something like 2% annual growth these days.

Of 135 US companies in the S&P 500 that have reported results, 68.9% beat expectations, higher than the rate over the previous four quarters.

Boeing said it had net income of $1.3 billion, or $1.86 a share, in the third quarter, up from $1.1 billion, or $1.51 a share, in the year-earlier period. The company blew past profit and sales estimates and raised its outlook for the full year. Shares dropped more than 4%. I don’t really understand that one, but Boeing is not a Wall Street darling this year.
AT&T reported adjusted third-quarter earnings of 63 cents a share on revenue of $32.96 billion. Analysts were looking for 64 cents a share on revenue of $33.22 billion.

Yelp is an online review site; so I’m told; I’ve never used it. Yelp reported third quarter results beat estimates but they issued weak guidance. Shares were slammed 15%.

US Bancorp said it earned a little more than $1.47 billion in the quarter, up from just under $1.47 billion a year earlier. On a per-share basis, the bank earned 78 cents, up from 76 cents. Revenue increased 2% to $4.99 billion. The results were in line with estimates. US Bank’s nearly 3,200 branches throughout the upper Midwest and West make the bank’s financial results a dispatch from the land of shale oil, which has fueled economic activity throughout the region. One sign: Lending by US bank for construction and development in the third quarter rose 27.6% from a year earlier, to $8.9 billion.

Tomorrow’s earnings calendar includes Microsoft, GM and 3M.

Yesterday we learned sales of previously owned homes just hit the highest level in a year. The latest numbers show new home sales surging August, when they hit their highest level since 2008. Consumer sentiment is hitting its highest levels since the crisis. Claims for unemployment benefits hit the lowest level in 14 years. Job openings are surging, hitting their highest levels since 2001. And the US is on track for its best year of job growth since the late 1990s. Industrial production just saw its biggest month-on-month gain since 2010. And capacity utilization hit a post crisis high. Meanwhile, inflation remains almost nonexistent, by historical standards, and is running so low that it might prompt the Fed to do something dovish. Consumer borrowing costs are falling, with mortgage rates at super low levels. And gas prices have dropped, and that should result in big savings and a little extra money in your pocket, which will be promptly spent, which will prop up the economy. The economy is actually looking pretty good.

But according to a new study by economists Emmanuel Saez of the University of California, Berkeley, and Gabriel Zucman of the London School of Economics, the middle class is getting killed. The middle-class share of American wealth has been shrinking for the better part of three decades and recently fell to its lowest level since 1940. In this case, “middle class” is defined rather expansively as the bottom 90% of all Americans. “Wealth” is the total of home equity, stock and bond holdings, pension plans and other assets, minus debt. The two big reasons why the middle class is getting clobbered? Inflation adjusted incomes have been stagnant for a few decades now, but debt has increased. Along with rising debt levels, stagnant wages have made it impossible for most families to save very much money, and so all the wealth the middle class accumulated since 1940 is gone.

If you want to make God laugh, tell him about your plans.