They often say that the cure for high prices is high prices.
The idea is that when the price for something goes up by too much, fewer people will be willing or able to pay for it. And so demand comes down, and in turn the price comes down.
But while inflation has indeed been running hot, the problem — ironically — is that consumers and businesses are in unusually strong financial positions. And while this may prevent any economic slowdown from becoming economic calamity, it’s also a curse in that it has enabled consumers and businesses to pay the higher prices.
This complicated mess was on full display last week.
Biggest jump in prices in 40 years
On Friday, we learned the consumer price index (CPI) in May rose 1.0% month-over-month, driven by a 3.9% jump in energy prices. CPI was up 8.6% from a year ago, the biggest jump since December 1981.
Excluding food and energy prices, which tend to be much more volatile in the short-run, core CPI was up 0.6%. This reflects a 6.0% gain from a year ago, which remains below the peak of 6.4% print in March.
Sure, the Federal Reserve tends to focus more on core prices. But any way you look at these numbers, inflation is still clearly high. (Bear in mind that these are May numbers.)
According to AAA, the average price of a gallon of regular unleaded gasoline reached an all-time high of $5.010 on Sunday. This is up from $3.077 from a year ago, a 63% increase.
Nevertheless, despite record high prices, there hasn’t been a drop-off in demand. In fact, weekly data from the Energy Information Administration shows demand is at similar levels as a year ago.
It may go without saying that rising gas prices are having a greater impact on lower income households. According to Bank of America’s internal data, average gas spending as a share of total card spending per lower income household was 9.5% during the week ending May 28. This compares to 7.8% for the average household.
Another one of the hottest categories in the CPI report was airline fares, which surged a whopping 12.6% from April. Prices are up 37.8% from a year ago.
But people are refusing to put their lives on hold. They’re traveling, they’re dining out, and they’re going to live events. This is a lot of discretionary spending. Check out the chart below from Kastle Systems.¹
Why are consumers still spending? They are in strong financial positions: These folks accumulated a lot of savings while also paying down debt, giving them the flexibility to spend some savings and accumulate some debt when needed. That’s kinda the whole point of shoring up your finances isn’t it?
According to Federal Reserve data released Tuesday, consumer credit balances increased by $38.1 billion in April. This consisted of a $20.3 billion gain in non-revolving credit, which includes student debt and auto loans, and a $17.8 billion rise in revolving credit, which is mostly about credit cards.
At $1.103 trillion, total outstanding revolving credit balances are now above pre-pandemic record levels. Some of the increase is likely due to some consumers getting financially stretched amid historically high inflation.
But as the chart below shows, consumer credit balances have increased over time and have moved with economic growth. It’s a reminder that context matters when talking about debt levels.
Here’s Wells Fargo with some more context: “So far, by most measures household borrowing remains far from a point of concern. As a share of disposable personal income, consumer credit still remains below its pre-pandemic position at just around 25%. Further, many measures of consumers monthly or quarterly debt obligations as a share of income remain near record lows…”
According to Bank of America’s internal data, savings and checking account balances continue to be much higher today than they were before the pandemic. Furthermore, credit card spending as a share of card spending are right where they were before the pandemic. This is across all income categories.
But just because consumers’ strong finances are enabling them to pay up doesn’t mean they have to like it.
In fact, the University of Michigan’s consumer sentiment index tumbled to a record low this month amid concerns over inflation. Here’s a historical chart from Charlie Bilello, founder of Compound Capital Advisors.
Here’s some color from the University of Michigan’s report released Friday: “Consumers' assessments of their personal financial situation worsened about 20%. Forty-six percent of consumers attributed their negative views to inflation, up from 38% in May; this share has only been exceeded once since 1981, during the Great Recession. Overall, gas prices weighed heavily on consumers, which was no surprise given the 65 cent increase in national gas prices from last month (AAA). Half of all consumers spontaneously mentioned gas during their interviews, compared with 30% in May and only 13% a year ago.“
The most important thing to remember about sentiment is that it’s been cratering for a full year, a period which has seen consumer spending only trend higher. It’s a bullish contradiction, which will likely continue to hold as long as consumers can afford to pay.
Let’s talk about housing 🏘
While airline fare inflation has been white hot, it only accounts for about 0.7% of CPI.
Shelter, however, accounts for a whopping 32% of CPI. Indeed, anyone who makes monthly mortgage or rent payments understands that housing is the biggest expenditure.
Rent of primary residence (a.k.a., tenants’ rent) and owners’ equivalent rent (i.e., how much a homeowner would have to pay to rent their currently owned home) each increased by 0.6% in May from a month ago. The latter metric is at its highest level since August 1990. While that may look like a small number, it piles up very quickly as it compounds.
The chart below from the White House Council of Economic Advisors shows how housing has grown as a driver of inflation.
For something a little more intuitive, check out the chart below from Goldman Sachs. According to their calculations, the median monthly payment of a 30-year mortgage is up 56% from a year ago.
This is due to a combination of surging home prices and rising mortgage rates.
However, housing seems to be a category where higher prices are having an impact on demand.
From Freddie Mac: “After little movement the last few weeks, mortgage rates rose again on the back of increased economic activity and incoming inflation data. The housing market is incredibly rate-sensitive, so as mortgage rates increase suddenly, demand again is pulling back. The material decline in purchase activity, combined with the rising supply of homes for sale, will cause a deceleration in price growth to more normal levels, providing some relief for buyers still interested in purchasing a home.“
Indeed, according to the Mortgage Bankers Association, purchase and refinance application activity last week fell to its lowest level in 22 years. Bill McBride, author of Calculated Risk, charted the slowdown:
Furthermore, home prices may be on their way to cooling. Here’s Redfin on the four weeks ending June 5: “On average, 5.3% of homes for sale each week had a price drop. Overall, 21.2% dropped their price in the past four weeks, up from 15.2% a month earlier and 10.3% a year ago. This was the highest share since October 2019.“
The big picture
There’s quite a bit of tension in the economy right now. On one hand, you have a Federal Reserve aggressively tightening monetary policy in its effort to cool inflation by slowing the economy. On the other hand, you have an economy bolstered by massive tailwinds that wants to keep growing.
Supply chains, meanwhile, remain stretched while an ongoing war in Ukraine continues to put pressure on food and energy prices.
So while economic growth has been showing signs of deceleration and the labor market has been getting less hot, it’s pretty clear that none of this has moved enough for inflation to move decidedly lower.
The ball is now back in the Fed’s court. On Tuesday and Wednesday, the central bank meets for its monetary policy setting meeting. It’s widely expected that the Fed will raise rates by another 50 basis points. Fed watchers will be more interested in what Fed Chair Jay Powell says about the future path of monetary policy with inflation measure remaining so high.
As far as investors are concerned, all of this means uncertainty continues to be high. While earnings have been strong and expectations for earnings growth has been resilient, valuations are likely to remain depressed until there’s a little more certainty regarding the outlook for inflation.
Related from TKer:
📉 Stocks plunge: The S&P 500 fell 5.1% last week. It was the worst week since January. The index is now down 18.7% from its January 3 closing high of 4796.56, but just marginally above its May 19 closing low of 3,900.79. For more on market volatility, read this and this. If you wanna read up on bear markets, read this.
It’s important to keep in mind that expectations for earnings continue to hold up. Read more here.
📆 Last week in the economy: We got the April consumer credit report, the May consumer price index report, the June consumer sentiment report, and a handful of high-frequency updates on mortgage applications, mortgages rates, gas prices, and office occupancy rates. I addressed all of these above.
🧳 Evidence of a cooling jobs market: Initial claims for unemployment insurance benefits climbed to 229,000 during the week ending June 4. This is the highest weekly tally since the week ending January 15. Economists were quick to note that the number could be off due to seasonal quirks tied to the Memorial Day holiday. Still, an uptick in weekly claims would be in line with other data signaling that the labor market is cooling. Read more about that here.
Up the road 🛣
The Federal Reserve holds its Federal Open Market Committee meeting on Tuesday and Wednesday. This is when the central bank decides on the path of monetary policy. Based on the economic data and the Fed’s communications since the previous meeting, experts widely expect the Fed to announce a 50 basis point hike in rates, raising its target rate range to 1.25-1.50%.
In the wake of Friday’s hot CPI report, it’ll be particularly interesting to see what the Fed will say about what they’re seeing in the economic data and what they signal about the outlook for rate hikes.
Sam Ro is the founder of Tk.co. Follow him on Twitter at @SamRo