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Consumer Prices Fall in March

Consumer Price IndexEnlarge GraphThe 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 is associated with rising wages. Deflation causes a lot of economic problems, especially for the Fed. Since interest rates cannot 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 are not rising, inflation can cause disposable incomes to shrink, which is a negative for the economy.

Inflation is also a debtor’s best friend. As inflation increases, wages and prices increase, which means that 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 could 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 is not overly concerned about inflation. As long as unemployment is elevated and inflation is below 2%, the Fed will consider themselves to be failing at both of their mandates – price stability and unemployment.

It is important to remember that the Consumer Price Index is not a “cost-of-living” index. It is 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.

Gasoline prices drove the decrease

Energy prices drove the decrease. Prices for the energy index dropped 2.6% in March, the largest decline in over two years. The gasoline price index fell 4.4%, which accounted for 80% of the decrease. Food prices were unchanged. Ex-food and energy, prices increased .1%, which is still too low for the Fed.

This report will probably hold the hawks on the Fed (Plosser, Fisher, and Lacker) at bay and allow them to continue to pursue quantitative easing. While a drop in energy prices is welcome, the Fed still fears deflation and will maintain ultra-low interest rates and continue with asset purchases until unemployment falls below 6%.

Implications for the home builders

Increases in raw material costs will hurt home builders, like Lennar (LEN), Toll Brothers (TOL), and KB Homes (KBH), if they cannot pass on those increased costs to home buyers. While we have seen large increases in the S&P/Case-Schiller and the FHFA Home Price Index, those indices measure house price inflation on existing homes. Home builders compete against existing homes, but double digit increases in existing homes don’t necessarily translate into double digit increases in new home prices. Home builders have been reporting new house inflation of low single-digits, and firms within the sector with December fiscal years will begin announcing earnings soon. Analysts will undoubtedly be focusing on margins.

We are starting to see shortages of construction workers as well, which means that home builders will have additional margin pressures as labor costs increase. That said, home building is coming back from such a depressed level that margins are still expanding as revenues increase. At some point, that will reverse, and profit margins will begin to compress.

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