Consumer Price Index
The Labor Department reported that the Consumer Price Index rose 0.4% in April, and 1.1% on a year-over-year basis. The core rate of inflation, which excludes food and energy, rose 0.2% in April, and 2.1% on a year-over-year basis. What accounted for the significant month-over-month increase in the Consumer Price Index was the 8.1% increase in gasoline prices. Yet it is the 8.9% decline in energy prices over the past year that is depressing the year-over-year increase in the Consumer Price Index to just 1.1%. What is lifting the year-over-year rate of inflation is the 3%+ increases in healthcare expenses and rents.
The Labor Department also reported that average hourly earnings for all employees increased 2.5% from April 2015 to April 2016. Even if we account for changes in the number of hours worked, the increase is still 2.5%. This is a slight improvement from the 2.3% increase we saw in the year-ago period, and there is clearly a very modest uptrend in the annualized percentage increase, as can be seen below.
Source: Department of Labor, Evercore ISI, FactSet, as of April 30, 2016. Gray-shaded areas indicate periods of recession.
The picture changes quite dramatically, however, when we account for inflation to compute real average hourly earnings. One year ago the year-over-year increase in the Consumer Price Index was a modestly negative 0.1%, which meant that a 2.3% annualized increase in average hourly earnings resulted in a 2.4% increase in real average hourly earnings. Today the year-over-year increase in the Consumer Price Index has risen to 1.1%. Therefore, a 2.5% annualized increase in average hourly earnings results in a 1.4% increase in real average hourly earnings. So real earnings growth has declined from 2.4% to 1.4% over the past year.
As the year-over-year comparisons for energy prices narrow in the months ahead, the overall CPI of 1.1% is likely to move closer to the core CPI of 2.1% on an annualized basis. Energy prices, led by oil, need not increase any further from current levels for this to occur. If there is not a commensurate increase in average hourly earnings growth, then real wages will continue to decline. The reason that real average hourly earnings is the most important leading indicator that we follow is that it is the fuel that drives our overall economic growth.
The Fuel for Economic Growth
Consumer spending accounts for approximately 70% of US economic growth. It is often assumed that job creation is the primary driver of consumer spending growth, which is the reason that there is so much focus on the monthly jobs report, but it is not. New jobs do lead to additional income that is spent on goods and services, but it is the rising incomes of all those workers already employed that is the primary driver of consumer spending, and by consequence, economic growth. Job creation is primarily the result of growth in consumer spending. Therefore, income is a primary driver of consumer spending, while job growth is a secondary driver.
The reason that we focus on average hourly earnings as a measurement of income is that it is the best measurement of US consumer purchasing power. The reason we focus on real, or inflation-adjusted, income is that economic growth is reported in real terms. Historically, a decline in real average hourly earnings growth leads a decline in real consumer spending growth, which is what drives real economic growth. The decline in real income over the past year has led slower rates of real consumer spending and economic growth.
We expect the rate of inflation to continue rising at a faster rate than average hourly earnings in the year ahead. As a result, we are forecasting a continued slowdown in the rate of consumer spending growth that will result in a tepid growth rate of 1% for the US economy in 2016.
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