With a small possibility that later today the Fed may hike rates for the first time in nearly a decade, and if not today then in 65 days (per the Bank of America countdown to the repeat of the “Ghost of 1937“) at the September 17 meeting on which consensus has congregated as the historic rate hike day, there is one particular chart that if not readers, then certainly the Fed, should focus on: the near historic difference between the two primary inflation measures, core CPI and the Fed’s preferred, core PCE…
which is now at the lowest level since the financial crisis.
This in turn begs the question: if the Fed, as it has repeatedly hinted, indeed intends to hike rates at a time when Core PCE is running the lowest in nearly four years, will the Fed make a grave mistake which impacts if not so much the people (after all the welfare of the vast majority of the US population has never been a consideration of the Fed) but of those corporations and banks whose existence and prosperity is the primary directive behind the Fed’s very existence.
Here is Bank of America commenting on the ongoing divergence between the two inflationary series:
In our view, there is a sizable risk the Fed is underestimating the size and persistence of the inflation gap. The only inflation measure that has shown any recent upside has been core CPI, which continues to diverge from the Fed’s preferred core PCE measure (Chart 3). Core PPI (excluding volatile trade services) and import prices of consumer goods fell in May. Earlier in the year, Yellen said inflation need not rise to start the hiking cycle, it just cannot fall. When she spoke, core PCE inflation was 1.4%; the most recent reading is 1.2%.
So is inflation really as low as the PCE suggests? Not at all, in fact in many ways the CPI is far more accurate, because recall that CPI accounts far better for Owners’ Equivalent Rent and the price of housing…
… than the Core PCE, which however is said to betters represent healthcare costs for individuals (if not corporations).
Here is a quick primer on the difference between the two metric:
The two indexes frequently diverge because they are constructed differently. While the weights in the CPI basket change only every few years, the PCE’s change each month, better capturing consumers’ tendency to shift from more expensive commodities and outlets to cheaper ones. The CPI’s weights are also determined by what consumers say they spend, whereas the PCE index is based on what they actually spend…. As a result the CPI assigns much more weight to rent and housing and much less to health care. PCE inflation over time typically runs about 0.3% below CPI inflation, but the current divergence, at 0.7%, is the largest in more than a decade, according to Goldman Sachs.
This was written a year ago. Now the divergence is even greater.
The reason appears to be the divergent behavior of rent and health care. Rent inflation has been relatively firm lately, reflecting strong demand by households who no longer qualify for mortgages or lost their home to foreclosure. Rents have an outsized impact on the CPI because they are used to determine the cost of owner-occupied as well as rental housing. Meanwhile, as has been widely discussed, medical inflation has eased notably in recent years. No one is sure why; the Obama Administration credits cost controls implemented under the Affordable Care Act. The weak economy, which has forced employers and employees to curb consumption and forced providers to control costs better, is almost certainly a factor, too.
Indeed, as shown below, rents recently soared to the highest ever, growing at a pace far greater than 2% Y/Y…
… driven by the collapse in US home affordability and homeownership.
The Economist’s take away:
This means that to the extent CPI inflation overstates what consumers spend on housing and understates what they spend on health, it is overstating the cost of living. To be sure, workers do not see all the benefit of lower health inflation since their employers and the federal government pay most of the cost . But over time this ought to translate into higher take-home pay as money that would have otherwise gone to benefits goes to wages instead. It’s a helpful reminder of how much consumers stand to benefit from any reforms that reduce health care costs.
And this is where the Economist is wrong, because precisely of its conventional, and incorrect, explanation of healthcare costs.
On the surface, yes, health costs appear low to consumers for one simple reason: insurance companies have delayed implementing the full price pass-throughs so far. But that has not prevented, and in fact the law has forced, corporations to factor in the new costs. As a result in the US there is a curious split: on one hand unit labor costs are soaring, and just experienced the biggest 6 month surge since 2007…
… and on the other, wages of non-supervisory workers which amount to over 80% of the population are near recessionary levels, and below half the Fed’s preferred wage inflation level of 4.5%.
This means that as a result of Obamacare, labor costs for corporations are already through the roof, and since every spare dollar allocated to SG&A is allotted to paying for Obama’s “Affordable” Care Act, there is virtually nothing left over for wage growth.
This explains both why CPI is rising (not enough) as it captures some (not all) of the soaring rent and OER costs in the economy, even as the PCE is sliding (for now).
It also explains why while the US consumer is seemingly “deflating” (just ask anyone who buys food and rents if their cost of living is lower) US corporations have finally hit their profit maximization limits. In fact, as the following chart from Bloomberg shows, after peaking recently, corporate margins are slowly but surely sliding, a massive red flag for anyone who is bullish stocks at these levels.
Which brings us to the first conclusion: if and when the Fed hikes, it will surely not have a big impact on the cost of living of the average American. It will however, have a profound impact on corporate profits, which will find themselves squeezed not only on the income statement side thanks to soaring health costs, but on the balance sheet side as well, with rising rates suddenly manifesting themselves not only in cost of capital discounting but in rising interest expenses, not to mention even more cost pass throughs by insurnace companies.
In other words, a tiny rate hike will have cascading effects on a corporate sector which has already cut costs and expenses to the bone, and has in recent quarters begun to suffer margin contraction.
Needless to say in a world of declining revenue growth, such as this one, the only thing that kept companies afloat and growing EPS was profit margin growth. With that gone, both the EPS growth and the multiple expansion cases are thrown out of the window, as is the stock market rally which over the past 6 years has been the Fed’s one and only “transmission mechanism.” Crash stocks, and you have if not a depression then surely a recession in a few months.
As for the second conclusion, dear average Americans: the Obamacare inflationary juggernaut is coming for you next . As we reported a month ago, after staying dormant for years (thanks to the abovementioned onboarding of Obamacare costs by coroprations), suddenly medical care service inflation exploded in April: at 0.7% it was the highest since 2007.
Or, as we explained in May, “The US Consumer Is About To be Crushed: The Obamacare Inflationary Deluge Arrives.”
The bottom line: hike or no hike, healthcare inflation has arrived and is already spilling over from the corporate sector into the broader economy. As such the Fed is already far behind the curve, and frankly, when it comes to the spike in healthcare inflation that is just around the corner, no amount of rate hikes can do much if anything, at least no rate hike that won’t totally destroy the stock market. However, the one thing that the Fed does care, and can control, namely the stock market, is about to get punched by a double whammy as the rate hike sends healthcare costs surging even more, and in the process sends corporate profits tumbling. And the S&P.
In short: the Fed can do nothing to prevent the incipient healthcare inflation; it’s too late for that. However, with a rate hike, as small as it is, the Fed can and will almost certainly start a chain of events that results in the “ghost of 1937″ waking up. We don’t know if, like during the first Great Depression, it leads to a 50% plunge in stocks, but for those long risk here, it hardly makes sense to stick around and find out.
