What's Driving Inflation? Here's A Hint

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Includes: IYR, REZ
by: University of Maryland REC Investments

Summary

With a Fed rate hike and major macro moves outside of the US, the dollar is once again beginning to appreciate.

As a result, consumer spending has weakened and inflation remains relatively low.

Mortgages are becoming more expensive, and coupled with relatively expensive residential real estate, we expect a check-back in the coming quarters.

inflation

By Zach Wohlberg

With the Federal Reserve (hereafter "Fed") recently increasing interest rates, there has a been a lot of talk about the surprisingly low inflation rate. The most recent Fed Minutes voiced the concern of several Fed officials, prior to the raising of interest rates, that inflation will not reach the desired 2% rate targeted by the Fed. By definition, inflation is the rate that represents the rise in general prices of goods and the decline in purchasing power of the dollar. When interest rates are low, otherwise known as easy money policy, it is expected for there to be higher inflation, because more money is in supply due to the cost of loans being less. This hasn't occurred due to several factors and the lack of this occurrence is a major cause of concern for the Fed.

With the Fed using a tight money policy, added with most countries around the world like China (in depreciating the yuan) and the EU (with its current Quantitative Easing policy) doing the opposite, the dollar continues to appreciate. A stronger dollar leads to the cost of American goods increasing for other countries and a decrease in the price of imports for American consumers. This has put downward pressure on domestic prices and has caused the inflation rate to decrease.

The price of oil has dramatically dropped over the last few months, recently falling below $30 a barrel -- the lowest it has been since the early 2000s. This price decrease has led to over $100 billion dollars in savings for Americans, while US energy corporations are suffering. This increase in savings for US consumers was expected to lead to an increase in consumer spending, which would in turn cause inflation to rise. Thus, low prices oil should benefit the Fed's plan over the past number of years to stimulate the economy.

Instead, while the pace of consumer spending is slowly increasing, the personal savings rate is at 5.5%, which is close to the highest it has been in three years. So our question is: is this the new normal? Has the US consumer changed its spending habits as a result of fear that still lingers from the 2008 crisis? Although consumer confidence is going up (it rose from 92.6 to 96.5 this past November), we still may be seeing lingering effects of the recession with consumers more willing to save their extra money then spend it, which can downwardly affect inflation. There are additional factors worldwide that may also take a toll on consumer confidence and their willingness to spend money. The global markets continue to be affected by the weak signs coming from China, with the continuing of the devaluation of the yuan coupled with the poor manufacturing reports, as well as increased international tension with Saudi Arabia and Iran.

On a more positive note, wages have increased as employers have been posting record numbers of job openings in the recent months and the unemployment rate has fallen to 5%. Compensation for the non-farm business sector grew 3.4% in the third quarter compared with the same quarter a year ago. This increase in wages should result in more consumer spending and an uptick in inflation, but many consumers are either being paid minimum wage or being employed part-time -- a fact that is preventing them from making enough money to become spenders, the likes of which are expected to boost the economy and increase inflation. This relationship of unemployment and inflation is portrayed in the Phillips Curve, which states that as unemployment goes down inflation should go up. However, our economy hasn't seen increases in inflation, even though our unemployment rate continues to decrease. This may have to do with the 5% unemployment rate not accurately factoring in both the quantity of part-time workers and the minimum wage that most workers are receiving.

These factors are why many Fed officials are concerned with disinflation, and why many skeptics are saying the Fed acted too quickly in rising interest rates. Disinflation together with higher interest rates can have many negative consequences such as leading to more non-performing loans. Slowing inflation negatively affects people in debt, for example a mortgage on a home, because the real value of your debt is going up. Money is worth less when there is slowing inflation and since debt remains the same, it is as if your debt is increasing. In the past, as inflation slows down, the amount of non performing loans have increased.

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(Source: St. Louis Fed)

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(Source: Macro Trends.Net)

At the end of 2001 and beginning of 2002, inflation dropped from around 4% to about 1.4% and at the same time the number of non-performing loans went up around .5% and then from 2008 to 2009 inflation went from 5.6% to -2% and at the same time the number of non performing loans went up between 3% and 4%.

While inflation continues to remain low, US home prices have continued to increase. The S&P/Case-Shiller Home Price Index covering the entire nation rose 5.2% in the 12 months ended in October, stronger than the 4.9% increase in September. Higher prices combined with higher interest rates has lead to higher mortgages. At the same time demand for single family homes have increase. Purchases of new single-family homes rose to a seasonally adjusted annual rate of 495,000 in October, up 10.7% from September's revised 447,000. This increase in demand is reflective of millennials starting to move into single family housing. For a long time the generation of millennials were not contributing to the single family housing market, but there are several factors that are leading to them driving single family housing demand. Millennials are the most educated generation in US history making it more likely they buy homes. Additionally, millennials start getting married, on average, at around 25-26 years old, and the majority of millennials are now 24-25 meaning that millennials are starting to get married and moving out to the suburbs and buying homes.

The demand for single family housing going up along with more expensive mortgages and disinflation may be the beginning signs of a potential increase in non performing loans. With oil prices dropping into the 20s and the dollar continuing to appreciate, as foreign countries continue quantitative easing, disinflation may only get worse in the near future, causing the real value of mortgages to be even higher. While nobody is suggesting we are anywhere near the levels of the 2007-2008 financial crisis, it is something to pay attention to especially if consumers continue to be hesitant to spend and this disinflation continues.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.