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Fed At a Crossroads


Inflation, economic growth can't coexist.


Is the economy poised for a recovery, as the stock market seems to expect? Or are we in for another few more quarters of recession and/or slow growth? In this week's letter we take a look at consumer spending, inflation, and other data to see if we can find a clue or two to give us an idea of the direction of the economy. There's a lot of data, so let's jump right in. (Media note: Right now I'm slated to be on Kudlow and Company on Wednesday.)

Retail Sales Take a Dive

Many commentators, looking for a bullish lifeline, have pointed to the fact that retail sales grew in April by 1.8% over this time last year. But that is truly grasping at straws. Just last November they were growing at 6% year over year and have been dropping relentlessly for the last six months. And as good friend, fellow Minyanville Professor and data maven Greg Weldon points out, retail sales last November were 1.3% over inflation and now are a negative 2.1% below inflation. Retail sales are clearly headed down. (See, a must-read for those who need in-depth analysis of all things and data economic)

But there was growth. Gasoline sales were up 16.3%. And food sales were up 6.1%. 77% of the increase in retail sales this year has been from increases in food and gas sales. If you take out food and gas, retail sales are down by about 2% in the last three months.

The consumer is getting squeezed. Reuters did a rather anecdotal but revealing survey of Wal-Mart (WMT) buyers at the beginning of the month. They found a significant increase in store traffic from the end of the month to the first of the month. Surveys showed that shoppers were stretched on their budgets due to rising gas and food costs and simply had to wait until their monthly checks came to go to the store for food. Many indicated they had changed their buying habits, now shopping at lower-cost stores like Wal-Mart.

At the Mauldin household I must admit to a kind of food shock upon my return. I eat a lot of smoked turkey from a local grocery deli. Arriving back from South Africa last night, I sent my oldest son to the store to put in a supply for the next few days. My "regular" turkey that was about $5.99 a pound a few months ago is now selling for $8.99. That is considerably higher than the 5.9% food-at-home inflation rate that the folks who give us the CPI tell us is the case. Next time I'll find a less expensive brand, as the Reuters survey suggest shoppers all across the country are doing.

(I do recognize the inconsistency of saving a few dollars at home while I eat out at nice restaurants where the price increases are even greater. It's all about what's in your head. There are books and massive studies devoted to such behavior.)

"Leslie Dach, executive vice president of corporate affairs and government relations at Wal-Mart, said the cycle of shoppers running out of money in between paychecks and then flocking to its stores on payday is 'more pronounced, more visible.'

While many U.S. retailers are facing waning sales as shoppers cut back on purchases of clothes, jewelry or home furnishings, Wal-Mart's vast grocery business and its emphasis on low prices is spurring a resurgence at its U.S. stores and in its stock price." (Reuters)

But prices are actually up at Wal-Mart. And not just from food. Looking at the latest Commerce Department data, we find that US import prices are up 15% year over year. Even taking out gasoline, prices are up 6.2%. And it is somewhat surprising that it is only 6.2%. Why?

Because the dollar has fallen by more than 6%. The Chinese ambassador to the US, Mr. Zhou Wenzhong, recently pointed out that the Chinese renminbi has appreciated almost 19% since July of 2005. I've been writing for years that the Chinese would allow their currency to appreciate slowly and steadily for their own purposes and on their own schedule. They need to do so in order to contain their own rising inflation. Look for it to rise another 10% by the middle of next year.

Consider that because of the rise of the renminbi, the prices for oil and food imports in China have risen 20% less than for US consumers. And the prices charged to the US for China's goods are only about 4% higher. But that meager growth is up from only 1% last fall. Those (notably economics-challenged Senators Schumer and Graham) who have been pressing for China to allow its currency to rise are going to find that such a rise ultimately means higher prices for US consumers. Be careful what you wish for, Senators. You just might get it.

Lower consumer spending is not just due to gas and food. There is also a psychological component. Frederic Mishkin, one of Ben Bernanke's colleagues at the Fed, has done research that suggests the "typical American family will cut its spending by up to 7 cents for every dollar in housing wealth it loses. Given a 20% fall in prices, this adds up to a nationwide reduction in consumer spending of about $350 billion a year, or 2.5% of the U.S.'s gross domestic product. That's a big number - more than enough to tip the economy into recession." (Conde Nast)

And that's if the fall in prices is only 20%. I continue to put forth the proposition that we're going to see a slow Muddle Through Recovery, as the boost we got from Mortgage Equity Withdrawals during the last recession will not be available this time.

Accounting for Inflation

If beauty is in the eye of the beholder, inflation is in the eye of the statistician. Because the number you end up with is dependent on the models and assumptions you choose. As the chart below shows, there have been two major revisions to how inflation is figured, one in 1983 and another in 1998. (Thanks to Barry Ritholtz at The Big Picture for this source.)

Note that using the same methodology as was used in 1983, inflation would be around 11.6% today. Before 1983, the BLS used actual home prices to account for inflation. After that time, they used something called Owners Equivalent Rent (OER). This is the theoretical price a home would rent for. There are sound reasons to use OER and equally good reasons to use actual home prices (as is done in Europe). But both methods have flaws. You just have to pick a methodology and stick with it.

And there are reasons to think that OER may not rise as it would normally do in this part of the cycle, because so many homes which cannot sell are being rented out and rent prices might not rise as much as in past cycles.

Using actual home prices is only useful in an average sense over long periods of time. If you own a home with a 30-year mortgage you bought ten years ago, then you haven't experienced price inflation for ten years. You've seen the value of your home go up, but that isn't (necessarily) inflation. Your mortgage is the same. And a first-time buyer today has the potential to see a 30-50% deflation in home prices from a year ago if he's in the right area, like Florida or California.

Further, the OER tries to measure what a house would rent for. If someone pays more than that rental price, then there is some other factor at work. The Bureau of Labor Statistics suggests that this other factor is investment. If someone pays more for a house than the equivalent rental price because it's perceived as a good investment, then you're measuring apples and oranges. The OER tries to take out the investment angle.

Because the government agencies use OER, inflation was understated in the recent housing bubble. As home prices drop, OER would normally overstate inflation somewhat. If we had used actual home prices then inflation would have been overstated in the last six years, and now the CPI would be turning negative, even as gas and food are rising dramatically.

As I said, neither method is perfect. Over very long periods of time, either will give you reasonably accurate data. But over a time period as short as a few years, let alone a few months, there can be considerable "noise."

Also, notice in the chart that in 1998 the Clinton administration adopted new methodologies, among them hedonic pricing. Hedonic pricing suggests that as a product or service improves, the price for the equivalent item in today's market will fall. As an example, if we buy a computer that is twice as powerful as it was a few years ago, the statisticians assume that prices have fallen even if we pay the same for the computer.

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