Bias Disclaimer: Please refer to the post on my biases if you wish to read this post without having to guess where I am coming from.
I apologize for the lack of posts. These next two weeks I have a lot of studying to do so I may not be able to get that much out. I promise after June 2nd things will change.
Last week we got some more CPI data and once again inflation increased almost 50 bps. Some will say CPI with food and energy and is unimportant – the real number, 20 bps is very modest. I will argue that its not THAT modest. Annualizing at about 4.8% puts our real interest rates somewhere around 0. If you add in food and energy we have negative real interest rates – which have existed for quite some time now. Fixed income investors are not really being paid to invest in Treasury Bonds – which are essentially at this point the equivalent of putting cash under your mattress with any spread the difference between the risk that your house will be robbed or that the Government will default.
CPI with food and energy is very important. The reason why Bernanke says the inclusion of food and gas prices is unimportant is that it is irrelevant to him in his daily role of whatever the hell he does. In my day to day life the price of snow globes is meaningless, but may not be the case with snow globe enthusiasts – such as Corbin Bernsen. Since these price changes apparently come from outside forces, he as Head of the Fed believes he should only focus on containing the inflation that he can contain. The market has taken this to mean that food and gas is meaningless, and their misunderstanding of this concept is dangerous. Separating the CPI into these two numbers is the equivalent of taking a company's earnings and separating it into net income and net income (excluding extraordinary items and one time charges). Investors would not buy Company XYZ if 4 quarters running, their earnings had the similar one time charges. An analyst following the stock would (hopefully) pick up on this and bring it to the attention issuing a sell rating because earnings quality has diminished if not earnings in general.
I will contend that at times this number can be unimportant and difficult to analyze, if oil prices spike during a hurricane season and America has to pay more at the pump for a few months the economic significance will be minor. But when this happens continuously it becomes important – and more so to the stock market no matter whether Ben likes it or not. Since it is somewhat difficult to address the sustainability, of this type of inflation let's examine and increase in gas and food prices from the standpoint of a tax.
Since food and gas are necessary to the lives of just about everyone, they income inelastic – meaning that a change in income will not affect the quantity demanded. Food and gas consumption as a percentage of income decreases as income gets larger. There is only so much gas you can shove down your car and food down your throat, so those who have higher incomes will bear less of the incidence of such a price increase than those who earn less. In tax terms this is a regressive income tax. A regressive tax's rate decreases as one's income increases. The income tax we pay the federal government is the opposite – the tax rate increases alongside income.
The real problem with such a tax is that it is inconspicuous and difficult to plan for is that it is very painful for those living paycheck to paycheck. Regular income taxes are not changed often so when budgeting and planning, people can take the net pay number from their paystub and count on buying what they want to buy. If most people are anything like me, they spend a majority of their paycheck within the first few days – usually paying off bills. Items such as gas and food are bought weekly if not daily and the increases seen in them are not as obvious. If every morning I eat get a bagel and coffee, and the price has risen from $2.00 to 2.25, my breakfast expenses have risen 12.5%. In my mind (if I even notice…and I do), it only went up a measly quarter which I seem to find in my pockets all the time. In addition if I have a 10 gallon tank in my car that I have to fill up twice a week when gas rises from $2.50 to $2.75 per gallon my weekly gas expense jumps 10% from $50 to $55. On a monthly basis we are looking at around $100/month increase in expenses (with very conservative estimates). A family of four with three other hungry mouths will see these numbers add up quite quickly, but will they really see it?
Food and energy are consumed on the go – meaning they are not bought in bulk at the beginning of the month. They usually are not bought in bulk at the beginning of the month but bought continuously throughout – in small quantities. Since the quantities are small the price differentials are not noticed as much. Even for a housewife who does the shopping for a family of four. A 10% increase in food would not be much to raise an eyebrow on a grocery bill that is usually $100 and is now $110. Perhaps some items weren't on sale this week or maybe it was because she bought different dish detergent or what about those ice pops that the kids asked for. No matter what – there will always be something to explain this away as most people are not obsessed with inflation.
As the month wears and meals and visits to the pumps continue, people begin to notice that they may be tight for this month. The same housewife who went shopping at the grocery store now has to buy her son soccer cleats and her daughter a new pair of jeans. Since she is not aware quite why she is so tight, she believes that this is a "one time event" and puts these items on the charge card, so that they can live for the next week and a half. When the next week's paycheck comes, she pays down the debt along with her other bills and goes along her business until she is forced to do the same thing yet again at the end of the month except now she borrows more. The cycle more or less continues.
The biggest problem with a regressive tax such as this is that if it were really a normal income tax, people for the most part would see that it comes straight off the top and after a few months plan and budget it for it. I can tell you very accurately what my paycheck is going to be next month but will probably be wildly off on what I will spend on food. The randomness and stealth nature that surrounds such a tax causes people to get stuck at the end of the month forcing them to borrow to buy things they may want or need such as more food and energy. Complicating things is the regressive nature of such a tax. If the housewife was married to a husband who was earning more and the family was not living paycheck to paycheck, the extra money spent on food and gas was just taken away from their usual amount of money they save or invest each month as opposed to being borrowed at high interest rates (usually credit cards). So on one hand you have one group of people paying an extra 10 – 15% in credit card interest due to a 10% increase in fuel and food, and another not making a small 5-7% on the same dollar increase. So, for an equal $500 dollar rise in expenses the first family feels it as if it were $550 and the second family feels it as a $525 rise. As things start to compound and interest expense becomes greater this can quickly get out of hand.
So inflation in food and energy is a problem – a big one at that. Just because the actual price of other baskets of goods have not risen as much, the average consumer has seen them rise dramatically as a percentage of their income left after buying items necessary for survival. In fact, if Energy and Food continues to rise, the demand drop on the less elastic goods could cause prices to fall substantially. Therefore, when CPI minus food and energy didn't increase as much as expected and the prices of food and energy increased more than expected – there is a point at which the this spread may indicate a lower level of consumption – which is not a great economic sign. So, just because Bernanke doesn't pay attention to that number, and the consumer doesn't fully comprehend the number, does not mean the market should be exempt from the same logic.
-β
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