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Why inflation remains tame, while interest rates will stay low

The Consumer Price Index measures inflation at the retail level

Inflation is a double-edged sword. The Fed likes to see a little inflation, as it’s associated with rising wages. Deflation causes a lot of economic problems, especially for the Fed. Since interest rates can’t go below zero, if deflation increases, it causes real (inflation-adjusted) interest rates to increase, which is exactly what we don’t want to see in a depressed economy. On the other hand, if wages aren’t rising, inflation can cause disposable incomes to shrink, which is negative for the economy.

Inflation is also a debtor’s best friend. As inflation increases, wages and prices increase, which means the relative size of the debt decreases. Given the shaky state of most household balance sheets, the Fed would really like to create inflation, provided it results in increased wages. If wages don’t cooperate, the Fed may end up making matters worse—if commodity prices increase while wages stay flat, consumers end up with even less disposable income.

Increasing inflation has historically meant that the Fed was getting ready to raise interest rates. A disappointing inflation report would cause stocks and bonds to sell off as investors react to a tighter Fed. These days, the Fed isn’t overly concerned about inflation. As long as unemployment is elevated and inflation is below 2%, the Fed will consider itself to be failing at both of its mandates—price stability and unemployment.

It’s important to remember that the Consumer Price Index isn’t a “cost-of-living” index. It’s an academic construct that attempts to measure inflation. The basket of goods it uses may or may not be the same as your basket of goods.

Inflation is still too low to satisfy the Fed

Consumer prices at the retail level barely rose in March, with the index increasing 0.2%. Over the past year, prices rose 1.5%. Ex-food and energy prices rose 0.2%, which are still too low for the Fed.

This report will probably hold the hawks on the Fed at bay and allow them to continue to maintain ultra-low interest rates. The Fed wants to see annual inflation of about 2%.

As a general rule, a small bit of inflation almost acts as a lubricant for the economy. To the average American, 3% inflation and 3% wage growth feels a lot better than no inflation and no wage growth. While the Fed is always cognizant of the risk of 1970s-style hyper-inflation, we have a long way to go to get there. Without wage inflation, increased commodity prices are recessionary, not inflationary.

Implications for homebuilders

Increases in raw material costs will hurt homebuilders like Lennar (LEN), D.R. Horton (DHI), Toll Brothers (TOL), and PulteGroup (PHM) if they can’t pass on those increased costs to homebuyers. While we’ve seen large increases in the S&P/Case-Shiller and the FHFA Home Price Indexes, they measure house price inflation on existing homes. Homebuilders compete against existing homes, but double-digit increases in existing homes don’t necessarily translate into double-digit increases in new home prices.

We’re starting to see shortages of construction workers as well, which means that homebuilders will have additional margin pressures as labor costs increase. That said, homebuilding is coming back from such a depressed level that margins are still expanding as revenues increase. At some point, that trend will reverse, and profit margins will begin to compress. Investors who prefer to invest in the entire sector should look at the S&P SPDR Homebuilder ETF (XHB).

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