Tag: inflation
Asset Allocation Weekly – #55 “The Prices We Don’t See” (Posted 10/1/21)
Asset Allocation Weekly – #54 “The Supply Side Worry on Inflation” (Posted 9/24/21)
Asset Allocation Weekly (July 2, 2021)
by the Asset Allocation Committee | PDF
(Due to the Independence Day holiday, there will not be an accompanying podcast and chart book this week. The multimedia offerings associated with this report will resume next week, July 9.)
The Wall Street Journal Dollar Index, which tracks the dollar’s value relative to seven major currencies, has fallen nearly 10% since March 2020. Generally, when the dollar weakens it leads to an increase in the price of U.S. imports and a decrease in the price of U.S. exports. The drop in export prices may be good for U.S. exporters in the long term, but the rise in import prices may have a negative impact on consumers. For example, the recent rise in gasoline prices can at least be partially explained by the depreciation in the dollar. The rise in import prices has posed a dilemma for many U.S. firms that rely on imports. They can choose to raise prices and risk losing market share or they can maintain prices and accept smaller profit margins. In this report, we discuss how a weaker dollar may contribute to inflationary pressures.
Most trade is contracted and settled in U.S. dollars. As a result, it is relatively easy for Americans to purchase foreign goods and services from abroad. In the year ended in March, the value of imported consumer goods, automobiles, and food and beverage was equivalent to more than a quarter of all U.S. consumption spending. That being said, this dynamic does not always favor U.S. trade partners. Because trades are primarily transacted in U.S. dollars, exporters to the U.S. bear most of the currency risk. This is especially true in the initial stages of currency depreciation as contracts prevent foreign exporters from adjusting their prices in response to the weakening dollar. Exporters are initially forced to absorb the currency depreciation through narrower profit margins, all else being equal. As sales are implemented over time, however, the foreign exporters are able to adjust their prices. In other words, import prices are sticky in the short-run but flexible in the long-run. The impact currency has on trade can be seen in changes to a country’s balance of trade.
In the initial stages of currency depreciation, U.S. importers are incentivized to buy more goods and services before the contract ends, thus leading to an increase in imports. At the same time, U.S. exports remain stable as it takes time for firms to expand production to meet the new demand. The trade balance therefore tends to weaken. Over time, however, the decline in the trade balance reverses as consumers find alternatives to the more expensive imports and exporters are able to expand their capacity to meet the increase of foreign demand. The initial decline followed by an upward swing in the trade balance is referred to as the J-curve effect.
Despite the correlation between the dollar and import prices, firms don’t always have the leeway to push the adjustment onto consumers. During the Great Recession of 2008-2009 and the period immediately following, merchandise import prices significantly outpaced the rise in consumer prices. The discrepancy is possibly related to economic conditions. In the months leading up to the recession, there weren’t many signs of significant supply chain disruptions. As a result, many firms were hesitant to push the increase in import prices onto their consumers out of fear of losing market share. Today, that isn’t the case. Supply chain disruptions and strong demand due to post-pandemic reopenings have made it easier for firms to push the rise in import prices onto their consumers. As a result, the rise in consumer prices closely matches the rise in import prices.
Although we are confident that the dollar’s depreciation has contributed to the rise in inflation, we still believe supply shortages and stronger demand are the primary drivers. However, if we are wrong, this would likely mean that elevated levels of inflation may be around longer than we have anticipated. In this case, the Fed would likely be forced to raise rates earlier than it has forecast, which would be bullish for the dollar and bearish for commodities.
Asset Allocation Weekly – #42 (Posted 6/18/21)
Asset Allocation Weekly – #41 (Posted 6/11/21)
Asset Allocation Weekly – #36 (Posted 4/23/21)
Asset Allocation Weekly (April 23, 2021)
by Asset Allocation Committee | PDF
A decade ago, the Rent Is Too Damn High Party became a viral sensation after a candidate for the New York governorship, Jimmy McMillan, announced lowering New York rent as his central platform. Now, over a decade later, rent prices in New York have finally started to fall. The pandemic-driven moratorium on evictions has likely played a role in declining prices in New York, but more of this change can likely be attributed to the phenomenon of people leaving cities in favor of suburban and rural areas. In fact, this migration out of major cities into the suburban and rural areas has been so pronounced that national rent prices have risen. Additionally, this increase in rental rates has led some economists to speculate that the uptick in rent prices is a sign that inflation is on the horizon. In this report, we will discuss how the rise in rental rates, and home prices for that matter, may not have as big of an impact on the Consumer Price Index (CPI) as many would claim.
The real estate market has changed dramatically since the start of the pandemic. Rent prices have dropped in the most populated cities, while suburban and rural areas have seen an increase. Since last year, the top 30 cities by population have seen a decline of roughly 6% in rent prices, while the rest of the country has seen a 4% rise. Purchase prices for homes have also risen sharply during the pandemic, with the S&P CoreLogic Case-Shiller index showing an 11% rise since January 2020. Because shelter is heavily weighted in the CPI, there have been concerns that increasing rental and home prices could push the overall CPI higher.
The CPI estimates the total cost of shelter for the urban areas in the country. Shelter prices account for approximately one-third of headline CPI and about 40% of core CPI. Its heavy weighting is due to the fact that it is the one service most consumers cannot avoid. Because of its weight, a significant movement in shelter prices can lead to huge swings in the index. This is one of the reasons people have been paying close attention to rental and home prices. Shelter has two major components: rent for primary residence and owners’ equivalent rent. Owners’ equivalent rent accounts for approximately 73% of the shelter price, while rent for primary residence accounts for 24%.[1]
Since homes are a capital investment, they are excluded from CPI. As a substitute, the index uses owners’ equivalent rent, which is the implicit rent that homeowners believe they would have to pay if they were to rent their own home. In order to gauge what the prospective rent went would be, the BLS asks consumers who own their primary residence the question, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” This approach reduces the impact home prices could have on CPI because the consumers have to take into account actual economic conditions when responding. Thus, consumers cannot simply answer the question by stating their mortgage payment.
In addition, the way shelter is calculated may also contribute to why CPI doesn’t seem to reflect the upturn in rental and home prices. Because 88% of the population lives in urban areas, CPI primarily tracks prices in cities. In fact, the top five heavily weighted cities ― New York, Los Angeles, Dallas, Philadelphia, and Chicago ― account for about one-fifth of the sample size. Therefore, any increase in rent prices and owners’ equivalent rent in areas outside these cities will not likely swing the index significantly. This helps explain why shelter prices in the CPI have waned in recent months, despite the rise in real estate purchase prices. Put another way, the BLS, which calculates CPI, has to create a weighted average for the entire economy. The problem of averaging is that there is a dispersion around an average that may be wide, but the average masks that issue.[2] It also makes sense to weight the average by population; after all, the central bank would probably not want to react to rising rent prices in Salina, KS, when rents are not rising in New York, NY.
In short, due to the way the CPI is constructed and sampled, increases in rental and home prices may not have a strong impact on the index, depending on the dispersion of pricing changes. Furthermore, the slowdown in the rise in shelter prices, as determined by CPI, is due to people moving out of major cities in favor of suburban and rural areas. Thus, we suspect inflation fears about the rise in rental prices are likely overblown, at least in terms of the CPI. On the other hand, because each person purchases their own unique basket of goods and services, some people may be experiencing rising prices in a way that is different from the average experience across the economy.
[1] The other two components are lodging away from home and tenants’ and household insurance.
[2] Often this situation is highlighted in statistics classes by the example of a person with their head in a 350o oven and foot in an ice bucket; on average, the person’s temperature is normal.
Weekly Geopolitical Report – What Population Aging Means for Global Inflation and Growth (April 19, 2021)
by Patrick Fearon-Hernandez, CFA | PDF
One key worry for investors these days is whether fiscal stimulus, loose monetary policy, and accelerating economic growth will spark runaway inflation. That concern has been a major factor in driving down fixed income prices and boosting bond yields since the start of the year. However, we’ve been arguing that any acceleration in consumer prices this year is likely to be fleeting. Much of the expected rise in inflation will simply reflect “base effects” as current prices are compared to the weak prices at the beginning of the coronavirus pandemic one year ago. Despite recent supply chain disruptions, such as the February freeze in Texas and the grounding of the Ever Given container ship in the Suez Canal, a lot of excess industrial capacity and unused labor exists in the U.S. and other major countries. The overall high availability of resources should help keep a lid on inflation for some time to come. In this report, we discuss yet another factor that will probably hamper inflation: population aging.