Yesterday’s post was a light and easy introduction to the idea of QE. We did QE at quite a high level because we don’t really need to get into the weeds about which bonds need to be bought, or for how long. The background that I wanted to provide was that we are in an easy money world where capital is relatively abundant.
But this post is not going to be like that. Oh No. If you want to understand why this creature called inflation has become so notoriously hard to find, its time to head out to the tall grass! Like hunters chasing after particularly vexing prey, we need to search for signs of its passage. There will be lots of piles of steaming turds we need to examine to evaluate the path of travel of our target. So let us dive in.
First up though, a warning: Statistics is not my specialization. And I don’t want to wade through equations where a graph or a chart will do the job. However, interpretation of data is a skill that you, dear reader certainly possess. And if you do not, I urge you to grab the opportunity to learn along with me! So, with this warning done, onward fellow hunter.
Developed world Inflation components
The minions who scurry around in the US to provide the inflation data we get have to first identify what things prices are to be tracked, and when tracked, what weight should we attach to them. It would be easy to track inflation by a single metric (See the McDonalds happy meal as an example), but it doesnt tell you as much as a broader indicator that more accurately represents how the median person spent their money.
Broadly, we can split an economy into goods and services. The US has a split as shown in the graph below
Fig 1 — Split between goods and services
As you can see, services moderately trumps goods in the inflation weights. Its almost 6:4. But the more interesting bit comes up going forward. If we drill down a bit more, the numbers show some more detail.
Fig 2 — Service sector breakup
The services part of the inflation data shows one very large component. That is shelter (proxy for housing). Now those who rent houses will nod in agreement and say, “that makes sense”. But for those who do not, and live in their own house, it is a bit of an odd one. For those who own houses, what is calculated is the imputed value of rent they would be paying themselves. This seems to be quite sensible in theory, but will make inflation numbers quite subjective for people who own their own houses.
The other major constituents are Medical services, transportation services and education. Alongside this, recreation and the miscellaneous items do count, but not for as much.
Now lets have a gander at the goods side of the equation
Fig 3 — Goods Sector Breakup
In goods as well, there are 2 big constituents. First is food, which seems enormous. Then comes energy, which is a fancy way of saying electricity and petrol bills. Apart from that there is buying of cars and spares, which makes me suspicious about whether I have made this chart correctly! But you can see that goods inflation gives about 50% to food and fuel.
So mixing the two charts together we get some pretty interesting outcomes.
Food, transportation (cars, fuel and services) along with shelter make up well over half of the basket of inflation (about 70%). For inflation to go up, these items need to move up. But, these are relatively sticky. Most people eat the same stuff they always do. They may splurge a bit by eating out some more, but it cant go up too much given the current data on how much the average American eats out! (For the curious, one in every 6 meals is eaten out).
Still, food prices can go up, can’t they? Not really. Food prices don’t double in the developed world week on week. The volatility is relatively small. Given that quantity does not change much, nor does quality of what you eat is relatively constant, that takes out food from the equation.
The data I used to base my conclusion is shamelessly stolen from here. I urge a visit to look at how the inflation value over a very long period has been trending down.
Well, transport and fuel are a very large component indeed. But lets have some flashbacks to some bad old days. Oil used to be 120 dollars a barrel in 2007-08. Today they are half what they were. (Even if double the price from the lows). Most commodities share the same fate. So the cost of buying cars and fuel and getting from place A to B have not changed much. The long term trends do indicate an increased distance every year since 1990, but not enough to offset the lower prices. (You will have to take my word for this).
Last comes housing. Now the US has pockets where the housing sector is certainly super hot (Hello San Francisco!). This is the only section in the big 3 of the inflation basket that actually increases at the Federal Reserve target rate of 2% (it is slightly higher). But even with the large weight, its relatively sticky. Housing inflation of 3% is imaginable. But in the absence of very large changes in income or population (or percentage of home ownership), rental costs are unlikely to change significantly beyond the trend rate.
The fastest growing measures of inflation are healthcare and education. They cause a large amount of noise among those affected (as they should), but as of today, they still make up only a relatively small proportion of the overall pie.For the present, they don’t do much more than round up the inflation number slightly. It seems very probable that healthcare at least will become a much larger component going forward though.
So the mystery has sort of been solved. The inflation has not vanished as such. It has been hidden amidst the weeds of food and transportation, and the housing crisis had made it hide in the basement for some time. But for those who stock wheelbarrows just in case they need it to cart currency for those loaves of bread, a look at the trends shows that it need not come out of storage anytime in the near future.
But this tale is not yet done. We will take a look at some of the assumptions that may change the inflation tale. And we still need to take a world tour through the developing world and Indian data! That will be for another day.