Homebuilder outlook: Why has producer inflation remained muted?

The Producer Price Index measures inflation at the wholesale level

Inflation at the wholesale level has been typically taken 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. A little inflation is considered a good thing. 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.

PPIEnlarge Graph

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 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 prices rose

Food prices drove the small increase, as they rose 1.0%. Prices for the energy index rose 0.3% in January after increasing 1.5% in December. Ex–food and energy prices increased 0.4%, which is still too low for the Fed.

Implications for homebuilders

Increases in raw material costs will hurt homebuilders, like Lennar (LEN), Toll Brothers (TOL), D.R. Horton (DHI), 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 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.

The latest NAHB Homebuilder Sentiment report showed a big drop in sentiment. Granted, some of that drop was due to lousy weather depressing traffic, but some was due to rising material prices a shortage of skilled labor. Increasing average selling prices have driven gross margins to record levels. Between increasing costs and the expected moderation of home price appreciation, that margin expansion is probably over.

To learn about other key releases, see the Market Realist series Must-know releases that will impact US debt securities this week.