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Why the Producer Price Index increasing 0.8% in June will hurt homebuilders

MR-PPIEnlarge GraphThe Producer Price Index measures inflation at the wholesale level

Analysts have typically taken inflation at the wholesale level to predict inflation at the consumer level. In a normal business environment, producers pass these increased costs to consumers, which would decrease disposable income if wages didn’t rise accordingly. Investors consider a little inflation a good thing. Deflation causes a lot of economic problems, especially for the Fed. Since interest rates can’t fall 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.

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 reacted 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.

Food and energy prices drove the increase

Food and energy prices drove the increase in inflation. Ex-food and energy prices increased 0.2%, which is still too low for the Fed. For the housing sector, construction materials increased 1.6%. Increasing lumber prices were offset by decreases in metal prices.

This report will certainly give the Fed comfort that it can continue with its ultra-low interest rate policy, although we know quantitative easing’s days are numbered. If anything, this report will discourage the Fed, as it suggests inflation could be too low.

Implications for homebuilders

Increases in raw material costs will hurt homebuilders, like Lennar (LEN), Toll Brothers (TOL), Standard Pacific (SPF), NVR, and KB Home (KBH), if they can’t pass on those increased costs to homebuyers. While we’ve seen large increases in the S&P (Standard & Poor’s)/Case-Shiller and the Federal Housing Finance Agency (FHFA) Home Price Index, those indices 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. Homebuilders have been reporting new house inflation of low single digits. While we have yet to see margin compression for the homebuilders, that’s always a concern.

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 will reverse, and profit margins will begin to compress.