Podcast Summary
No consensus on inflation theory: Economist Omer Sharif suggests a multi-faceted approach to understanding inflation, considering factors like supply and demand imbalances, monetary policy, and structural issues.
Despite the efforts of economists and central banks, there is currently no clear consensus on a definitive theory of inflation and its causes. This was a question raised on the Odd Lots podcast over a year ago, and with the recent surge in inflation, it has become an even more pressing issue. Even with the Federal Reserve's new flexible average inflation targeting regime, the length and severity of the current inflation remain uncertain. Our guest for this episode, Omer Sharif, a renowned economist and founder of Inflation Insights, shares his insights on the subject. He believes that while there are various theories and models, no single theory can fully explain inflation in all its complexities. Instead, a multi-faceted approach that considers various factors, such as supply and demand imbalances, monetary policy, and structural issues, may be more effective in understanding and forecasting inflation.
Understanding Inflation's Persistence: Despite extensive research, no single theory can fully explain inflation's persistence. Effective inflation forecasting depends on the specific time period and can be achieved through top-down or bottom-up approaches. The Fed's Phillips curve framework may not be reliable for longer time horizons.
Inflation is a constantly evolving process that is difficult to forecast due to its persistence, which varies across time. There is a vast academic literature dedicated to understanding inflation and its forecasting, but no single theory can fully explain it. The approach to forecasting inflation can be top-down or bottom-up, and the effectiveness of models depends on the specific time period. For instance, simple naive models, such as using the average of the last few quarters, can be effective when inflation has been stable for a long time. However, these models may not capture the time-varying nature of inflation persistence, making them less effective in other periods. The Federal Reserve's framework for understanding inflation, whether the old or new one, is based on the Phillips curve theory, which assumes a trade-off between inflation and employment. However, if the nature of inflation changes significantly over longer time horizons, the Phillips curve framework may not be a reliable guidepost for the Fed. Ultimately, the Fed's time horizon is around 3 years, so the Phillips curve may still be useful for them within that time frame.
Understanding the Different Measures of Inflation: The Fed focuses on Core PCE for monetary policy, while markets prefer CPI. Both measures have limitations and the interpretation depends on the context.
While there are a variety of measures for inflation, such as the Consumer Price Index (CPI) and the Fed's preferred measure, the Core Personal Consumption Expenditures (core PCE), the choice of which measure to focus on depends on the specific context. For the Fed, the Core PCE is the primary concern for monetary policy. However, for markets, the CPI is more important as it impacts pricing tips. The concepts of inflation indices themselves are a construct, and while they aim to reflect reality, there is debate over the extent to which they accurately capture inflation. The Fed has acknowledged that the Phillips curve, which historically linked unemployment and inflation, may not be as reliable as it once was, and they are now focusing on a range of indicators. Ultimately, the interpretation of inflation data depends on the specific context and the goals of the observer.
CPI excludes house prices and rents as direct measures of inflation: The CPI uses an Owner's Equivalent Rent index instead of direct measures to estimate housing costs, acknowledging the investment aspect of housing as separate from consumption
The Consumer Price Index (CPI) does not include house prices or rents as a direct measure of inflation due to its treatment as an asset rather than a consumption expense. This decision was made in the late 1970s and early 1980s when interest rates were volatile, leading to significant volatility in the CPI and making it difficult to gauge underlying inflation. Instead, the CPI uses an Owner's Equivalent Rent (OER) index to estimate the cost of shelter, focusing on the consumption aspect rather than the investment aspect of housing. The debate around this issue has been ongoing for decades, but the CPI's primary goal is to measure the cost of living for consumers, not the value of their assets. Principal Asset Management, as a leading real estate manager, recognizes the importance of understanding the housing market and its impact on inflation, but acknowledges the limitations of the CPI in fully capturing these trends.
CPI Rent Growth Lags Behind Private Market Data: The CPI for rent and owner equivalent rent only represents a small percentage of new renters each month, causing a lag in reflecting market rent increases. Major metro areas are starting to see rent growth, but overall, it's expected to be closer to historical norms.
While private market rent data may show significant increases, the Consumer Price Index (CPI) for rent and owner equivalent rent (OER) is unlikely to see the same magnitude of growth due to the way the CPI sample is constructed and the infrequent turnover in the rental market. The CPI only represents about 10-15% new renters each month, leading to a lag in reflecting market rent increases. Major metro areas like New York, Los Angeles, and Chicago, which have large weights in the rent index, are starting to stabilize and move up, but overall rent growth is expected to be closer to historical norms rather than the double-digit increases seen in private market data. Additionally, other components of the CPI, such as used cars, are currently contributing more to overall inflation than rent and OER combined.
Understanding Transitory Inflation: While some price increases may be temporary, others could be more persistent. Analyzing CPI dispersion, core CPI momentum, and specific component levels can help determine if inflation is transitory or not.
While there may be an increase in Operating Expenses (OER) and rent in the coming months, it is expected to be offset by the decrease in prices of certain transitory items, such as used cars. Transitory inflation refers to the idea that certain price increases, like those seen in used cars, are temporary and will not continue to accelerate at the same rate. To determine if inflation is transitory or not, one can look at the dispersion within the Consumer Price Index (CPI), the momentum within the core CPI, and the price levels of specific components compared to pre-pandemic trends. For example, airfares are currently below where they would be if they had continued on their pre-pandemic trend, indicating potential for upward pressure, while hotel rates are above, suggesting potential for a decrease. Overall, it's important to keep in perspective that while some price increases may be temporary, others may be more persistent and have a greater impact on the overall inflation picture.
Not all components of inflation are experiencing significant price increases: Despite some high-profile price increases, only about 85% of components in the Fed's preferred measure of inflation are currently showing price gains, which is only a few percentage points more than pre-pandemic levels. Expect a slowdown in core inflation by mid-2022.
While some components of inflation, such as used cars, rental cars, airplanes, hotels, and certain goods related to shipping and logistics, have shown significant price increases, the broader inflation picture may not be as concerning as it seems. According to the speaker, only about 85% of components in the Fed's preferred measure of inflation, the PCE, are currently showing price gains, which is only a few percentage points more than pre-pandemic levels. The speaker also emphasized that not all price movements can be attributed to macro or micro stories, but rather the way the methodology and seasonality of the index are constructed. For example, motor vehicle insurance, which saw a 2.5% decrease last month, has nothing to do with a big story and is simply due to seasonality. The speaker expects a slowdown in core inflation by the middle of 2022, with core PC potentially being closer to around 2%, whereas core CPI may still be punching along at around 2.5%. It's important to understand the intricacies of inflation data and not rely too heavily on narratives to explain price movements.
Inventory levels and used car markets indicate some normalization of inflation: Investors value detailed analysis of inflation components and evidence suggests some normalization may be occurring, despite ongoing risks
While there are risks to inflation being more persistent than expected, evidence from inventory levels and used car markets suggests some normalization may be occurring. Principal Asset Management's bottoms-up approach to analyzing inflation components is highly valued by investors, who seek to understand the drivers behind price movements and make informed decisions based on this detailed information. Despite some views that inflation is solely the result of the Fed's money printing, those actively managing money are receptive to more nuanced analyses.
Understanding sector-specific drivers of inflation: Firms like Inflation Insights use a bottom-up approach to forecast inflation by focusing on sector-specific drivers and maintaining a direct line of communication with the Bureau of Labor Statistics to provide clients with accurate and timely insights.
In the world of inflation forecasting, a bottom-up approach has become increasingly popular on the sell side. This approach focuses on understanding the specific drivers of inflation in various sectors, rather than relying solely on macroeconomic theories. Monetary policy plays a role, but its impact is limited in the short term, and only certain components of the inflation index are sensitive to policy changes. The pitch for a firm like Inflation Insights to institutional clients is threefold: delivering the best-in-class inflation forecast, providing detailed analysis and timely insights, and maintaining a direct line of communication with the Bureau of Labor Statistics. By combining deep sector expertise, timely analysis, and a strong track record, Inflation Insights aims to provide clients with an edge in the market.
Understanding Inflation: Choices in Data Depth and Alternative Sources: To effectively analyze inflation using the Consumer Price Index, choose the right level of detail based on resources and desired insights, and consider using alternative data sources for added perspective.
Understanding inflation, as measured by the Consumer Price Index (CPI), is a complex and ongoing learning process. With over 7,000 item area indexes and 211 broad components, it's crucial to make choices about how far to drill down. For example, when it comes to food, you might focus on broader indexes like the food at home and food away from home indices, and then drill down into specific components if needed. However, the level of detail and timeliness of your forecast will depend on your resources and the specific actionable insights you're looking for. Additionally, alternative data sources, such as online retailers, can be used to supplement official CPI data and provide additional insights, especially for components like airfares that can be difficult to forecast using traditional methods.
Monitoring wage growth for inflation trends: Wage growth and its impact on sectors like hospitality and limited service restaurants could indicate a more persistent inflation trend, but Delta variant and used car prices remain uncertain risks.
While there are alternative datasets like the Billion Prices Project and GasBuddy that can provide valuable insights into inflation, it's important to note that they focus more on goods prices rather than services prices. For a sustained upward move in inflation that could persist, investors should keep an eye on wage growth and its potential impact on sectors like hospitality and limited service restaurants. A persistent wage pass-through could indicate a more persistent inflation trend, but factors like the Delta variant and used car prices remain uncertain risks. Overall, while inflation may not be a major concern for monetary policy in the medium term, persistent wage growth and its impact on certain sectors could change that.
The mystery of apparel inflation: Apparel inflation is unpredictable and not easily explained by traditional methods. Hedonic adjustments, while useful, only account for a small fraction of apparel price changes.
Apparel inflation remains a mystery and defies traditional bottom-up analytical approaches. Despite years of analysis, there's no reliable method to forecast apparel prices other than recognizing seasonal patterns. Hedonic adjustments, which help account for changes in quality, apply only to goods and not services, making up only about 4-5% of the Consumer Price Index (CPI). Apparel is one of the few exceptions where hedonics are used. The BLS does not adjust for changes in service quality in areas like restaurants or hotels, leaving some room for controversy regarding the accuracy of CPI measurements. A notable example of a significant hedonics adjustment occurred in March 2017 when wireless plans shifted to unlimited data, leading to a significant drop in prices. However, these adjustments only impact a small fraction of the CPI, and their impact is most noticeable during large price movements. Overall, apparel inflation remains an enigma, and understanding its complexities requires recognizing its unique patterns and limitations.
Adjustments for changes in quality or quantity in CPI calculations: Hedonic regressions in CPI calculations can lead to significant changes, such as a 7% decline in wireless index and a 0.1% impact on monthly core CPI.
The Consumer Price Index (CPI) calculations involve adjustments for changes in quality or quantity, such as unlimited data plans in wireless services. These adjustments, known as hedonic regressions, can result in significant changes to the index, as seen in a 7% decline in the wireless index and a 10th of a percent impact on the monthly change in the core CPI. These adjustments are a standard methodology used by statistical agencies worldwide to calculate CPIs. However, economists are always on the lookout for potential paradigm shifts that could impact inflation, such as reshoring of manufacturing and supply chain disruptions. These shifts could lead to longer-term changes in inflation, but may not be easily captured through bottom-up forecasting. Overall, understanding inflation requires a combination of top-down and bottom-up analysis, especially with the current economic landscape being heavily influenced by reopening categories like used cars, airfares, and hotels.
Understanding the complexities of the Consumer Price Index: Exploring the intricacies of index construction, methodology, and seasonality is crucial for accurately understanding economic indicators like the Consumer Price Index.
Learning from this episode of Odd Lots is that understanding the complexities behind seemingly simple economic indicators, like the Consumer Price Index (CPI), requires a deep dive into the specific industries and methodologies involved. Omer Sharif, the guest on the podcast, emphasized the importance of not just looking at broad categories like semiconductors or shipping containers, but also delving into the intricacies of index construction, methodology, and seasonality. Even with decades of research, economists still struggle to accurately forecast inflation due to the unpredictable nature of certain industries and factors. For example, while it may seem straightforward to predict airfare prices with the abundance of information available online, it can be challenging to accurately forecast prices for other categories like mayonnaise or salad dressing. Exploring each of the 200 CPI components in depth, with stories about the industries and price derivation, could make for an interesting book or coffee table book. Ultimately, the episode highlights the importance of a nuanced understanding of economic indicators and the industries they represent.
