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Must-know: Inflation remains well-contained at the consumer level

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Consumer price inflation

Inflation is a double-edged sword. The Fed (or Federal Reserve) likes to see a little inflation because it’s associated with rising wages. But deflation causes a lot of economic problems, especially for the Fed.

Consumer Price Index

Interest rates can’t go below zero. So if deflation increases, it causes real inflation-adjusted—interest rates to increase. This 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. So this is a negative for the economy.

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Inflation is also a debtor’s best friend. As inflation increases, wages and prices increase. This 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. This is assuming that the inflation will increase wages.

If wages don’t cooperate, the Fed may end up making matters worse. If commodity prices increase while wages stay flat, consumers will end up with even less disposable income.

Historically, increasing inflation 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 considers itself to be failing at both of its mandates—unemployment and price stability.

It’s important to remember that the Consumer Price Index (or CPI) 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 comes in right at the Fed’s target

Consumer prices at the retail level decelerated in June. The index decreased 0.2% compared to a 0.1% increase in July. Over the past year, prices increased 1.7%. Ex-food and energy prices were flat. On a year-over-year basis, they were up 1.7%.

This report will probably hold the hawks in the Fed at bay. It’ll allow them to continue to maintain ultra-low interest rates. The Fed wants to see annual inflation of ~2%.

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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 feel a lot better than no inflation and no wage growth. While the Fed is always cognizant of the risk of 1970s–style hyperinflation, we’ve 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.

For more information on the homebuilders, click here.

We’ve seen large increases in the S&P/Case-Shiller Home Price and the FHFA (of Federal Housing Finance Agency) House Price indices. They measure house price inflation on existing homes. Homebuilders compete against existing homes. Double-digit increases in existing homes don’t necessarily translate into double-digit increases in new home prices.

We’re starting to see construction worker shortages too. This shortage means 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 SPDR S&P Homebuilders ETF (XHB).

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