By Neil Chapman, JD, CFA
Director, Chief Investment Officer
Chair Powell’s opinion is an important one since one of the Fed’s mandates is to promote price stability. Chair Powell maintained his opinion that the higher inflation rate is “transitory”. I will just note that according to the Oxford English Dictionary, transitory simply means “not permanent”. Based on that definition, the current higher inflation rate is almost surely transitory. In the post-pandemic world, it is likely impossible for anyone, including the Chairman of the Fed, to put a more precise timeframe on how long higher inflation will persist.
Another important consideration is just how high is the current inflation rate, relatively speaking. In that regard, you might have heard, “It’s not as high as it was in the 70’s,” implying that there is really no reason to be concerned about the inflation we are experiencing today. The 1970’s is generally known as a period of high inflation, and poor stock performance. But what if the inflation rate really is as high as it was in the 1970’s?
I will begin this discussion by clearly stating that this blog is meant to point out that measuring inflation itself is imprecise and subject to debate; and that, since the 1970’s, there has been a fairly significant change in how we (the Bureau of Labor Statistics (BLS)) measure inflation. It is not meant to incorporate all the variables affecting the calculation of the inflation rate, or crunch numbers to arrive at the most precise rate comparison.
The Consumer Price Index (CPI), also called “headline inflation”, is likely the most closely watched indicator of inflation, and the measure we will use here. Other measures of inflation are Core CPI, which excludes food and energy prices, and the Fed’s preferred measure, the personal consumption expenditures price index (PCE).
In the 1970’s, inflation, as measured by the CPI, was high. Specifically, by April 1973, year-over-year inflation was 5.1%; in August of that year, it rose to 7.5%. Annual inflation for 1973 came in at 6.2%. It was 11% the next year. The rate of inflation decreased for a period, but then it went up to 13.5% by 1980.
The BLS announced on July 13th of this year that the CPI rose 5.4 percent for the 12 months ending June. The BLS also noted that the CPI has been trending up every month since January, when the 12-month change was 1.4 percent. The 5.4 percent annual rate surprised many in the economic and investment world, causing much discussion and debate on both the level and persistency of this higher inflation rate. (The Fed has a target of 2% inflation, as measured by PCE, and the PCE price index for May increased 3.9 percent from one year ago.) As many noted, this was not the double-digit inflation experienced in the 1970’s.
However, the methodology used by the BLS to account for housing costs in the CPI calculation has changed since the 1970’s. Until 1983, the CPI included housing costs. But then the index was changed, and home prices no longer directly affected the index. Instead, the BLS makes a calculation of “owners’ equivalent rent,” which is based on the trend of costs to rent a home, not to buy one. The current approach, the BLS says, “measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes.” The CPI, according to BLS, is not supposed to include investments, and owning a house has aspects of both investment and consumption.
As we all know, home prices have increased dramatically over the past couple of years. According to one measure of home prices, the S&P CoreLogic Case-Shiller National Home Price Index, home prices in May saw an annual gain of 16.6% (the latest release), up from a 14.6% increase in April. The shelter portion of CPI, which includes rent and owner’s equivalent rent, increased at only a 2.6% annual pace through June. As shown in the chart below, home prices have increased at a much higher rate than owner’s equivalent rent.
If we used home prices, instead of owner’s equivalent rent, in the calculation of the CPI as was done in the 1970’s, the resulting inflation rate would be much higher. In round numbers, housing accounts for approximately one-third of the CPI. If we used the 16.6% annual gain in home prices instead of the 2.6% annual shelter increase in the current CPI calculation, as was done in the 1970’s, a back-of-the-envelope calculation would say that CPI increased at an annual rate of 8.3% (instead of 5.4%). This estimation is far from precise, in large part because the old index was based not just on purchase prices, but also on changing mortgage interest rates and on changing property taxes. It does show, however, that current inflation rates are more like inflation rates we saw in the 1970’s than most people might imagine.
Investors need to be aware that higher inflation is here, maybe higher than they might initially suspect, and it may be here for longer than they suspect. Financial plans should be updated to account for higher than anticipated inflation and determine the impact on lifestyle in coming years.