Inflation Not a Significant Problem - For Now

By Dirk van Dijk

The release of the CPI confirms what the PPI showed yesterday -- that inflation is not a significant problem at the moment. In May, consumer prices rose just 0.1% on both a headline and on a core basis, as falling food prices offset increases in gasoline prices.

Seasonal adjustment helped keep the reported increase in energy prices under control. The seasonally adjusted increase in gasoline prices was 3.1% for the month. What people actually paid at the pump jumped 9.6%. However, the effect of higher inflation readings a year ago, combined with the collapse of commodity prices last fall, left the year-over-year headline CPI with its biggest decline since 1950, falling 1.3%.

The index for housing fell by 0.1% for the third straight month, and for the fourth time in seven months (the other three were unchanged). This was largely due to a decline in household energy prices.

Note that natural gas prices have not come close to keeping up with the rise in oil prices. This has some interesting implications for the oil service sector. Firms that are tied to exploration and development of oil, like the deep-water drillers Transocean (RIG) (Analyst Report) and Diamond Offshore (DO) (Analyst Report) are much better positioned than the land drillers such as Patterson-UTI (PTEN) (Analyst Report) that are more tied natural gas drilling.

Medical Care inflation continued on its merry way, rising 0.3% for the month and up 3.2% over the last year. That is 4.7% ahead of overall inflation and 1.6% ahead of core inflation (more if you stripped out medical inflation from the rest of core inflation). Medical Care, despite making up over 16% of GDP only has a 6.4% weighting in the CPI. Education and communication prices increased by 0.3% for the month and are up 3.2% over the last year, mostly due to higher tuition costs.

It is worth noting that Health and Education is the only area where employment has been steadily increasing over the last year. Medical inflation consistently running well ahead of overall inflation is a serious problem, and has to be tackled soon. If we do not get a serious health care reform bill passed this year, and the problem is kicked down the road for another 16 years, the bankruptcy of the entire country cannot be ruled out.

Housing is by far the most important influence on the overall CPI -- totaling 43.4% of the total -- but that includes total costs to run the house. Owners equivalent rent (OER) has a 24.4% weighting in the index while regular rent paid to a landlord has a 6.0% weighting. OER is a bit of a strange duck in that it is based on a survey of homeowners about what they think it would cost them to rent an identical house across the street. Since not many homeowners spend their time checking out what rental rates are for homes in their neighborhood every month, that part of the CPI needs to be taken with a grain of salt.

The major take-away from the report is that inflation remains under control and that the Fed is under no immediate pressure to raise rates. With more overall slack in the system than at any previous point since the end of WWII, it will be hard for inflation to gain traction. There is simply no way for the wage side of a wage price spiral to take hold.

On the other hand, enormous quantities of money have been pumped into the system to compensate for the falling velocity of money. If that velocity were to pick up, it will be very hard for the Fed to drain the liquidity out of the system quickly. We could go from near-zero inflation to very high inflation seemingly overnight. That, however, is unlikely to happen this year, but remains a serious danger for mid-2010 and beyond.