Today we received the December reading for the Consumer Price Index, which is probably the most widely followed measure of consumer inflation in the US. The CPI increased 2.1% on a year-over-year basis in December, which is the highest rate of growth since June, 2014, and is slightly above the Fed's stated target for inflation. Some economists have become concerned because they believe that the Fed's suppression of interest rates to very low levels for eight years may now be sparking a surge in inflation. These fears are exacerbated by a recent acceleration in wage growth to the highest level since June, 2009. So given the acceleration in CPI and wage growth, are economists' fears about a sudden bout of runaway inflation justified?
In last week's Market Commentary, we addressed the acceleration in wage growth by showing that the recent trends in the labor market have actually been softening over the past few months if we adjust for inflation (as measured by the CPI). We provided a chart showing that the YOY growth rate in real (inflation-adjusted) wages declined to just 0.8% in November and December from as high as 2.5% in early 2015. We also showed the recent trend in weekly hours worked, which at 34.3 hours in December was tied for the lowest level since early 2014. These metrics show that although absolute wage levels are increasing at a better clip, the average consumer is working less and getting less bang for his buck with regard to his wage increases. At the same time, we've seen large numbers of people drop out of the labor force. If we aggregate all consumers throughout the economy, these trends have implications for consumer spending, the consumer savings rate, and economic growth.
A quick analysis of the numbers driving the headline CPI reveal some interesting things. In the table below, we show a breakdown of the CPI components, including their weightings in the index, and their month-over-month and year-over-year changes for the month of December. We have highlighted the items that grew at an above-average rate on a YOY basis. Almost across the board, the items that are becoming more expensive can best be described as necessities rather than discretionary, or "luxury" items. The average consumer is having to pay more for food away from home, energy, medical care (both services and commodities), shelter and car insurance. At the same time, prices for more discretionary items like apparel, automobiles (both new and used), alcoholic beverages, and airline fares are growing at a very slow rate if at all. This dichotomy not only shows that there are stresses on large segments of the population (the middle class), but it also has implications for economic growth.
Despite the acceleration in nominal wage growth, the average middle-class American is still not benefiting much from the overall growth in the economy. If large segments of the population are seeing their wage gains go to basic necessities like health care and housing, then they will: 1) have less money left over to spend on discretionary items; and 2) be more inclined to save their wage increases for retirement or emergencies rather than spending them. It's the latter point that I think many economists are missing. The wealthy continue to account for the overwhelming majority of the income and spending gains we've seen since the end of the Great Recession, even as the average middle-class consumer falls further behind in saving for retirement. As interest rates and energy prices continue to rise, it is unlikely that the middle class will get much relief unless our present course changes. Our economy will only grow at sustainably higher rates when more money gets into the hands of more consumers who feel less of a compulsion to save rather than spend it.
What conclusions can we draw?
- An acceleration in nominal wage growth is being increasingly offset by inflation, especially in non-discretionary products and services.
- The increase in inflation continues to be driven by more non-discretionary categories, disproportionately affecting the middle class.
- The Fed's monetary policy, a very blunt tool, has exacerbated the income/wealth gap even as it has supported moderate economic growth.
- The increase in inflation to above the Fed's stated target, regardless of its sources, will be sufficient for the Fed to continue policy normalization.
- Fiscal stimulus will likely be needed to offset the impact of Fed policy normalization.