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Three questions about inflation answered

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      By Stewart D. TaylorInvestment Grade Fixed Income Portfolio Manager, Eaton Vance Management and Jason DesLauriersInvestment Grade Fixed Income Trader, Eaton Vance Management

      Boston - In this piece, we attempt to answer three questions about inflation:

      • Why has the longest economic expansion since 1900 failed to generate inflation?
      • Why has inflation consistently fallen short of the Federal Reserve's 2% core personal consumption expenditures (PCE) goal?
      • Why do consumer prices seem to understate the price increases we experience in our everyday life?

      The explanation is simple. Persistent deflation in the cost of many goods has mostly offset the persistent inflation in the cost of services. Items like new automobiles, clothing, and household furnishings have become more affordable over the last two decades. At the same time services like healthcare, rent and tuition have become more expensive.

      Two distinct factors are responsible for much of the goods deflation. The first is globalization. Globalization affects inflation in two significant ways. It reduces local wages in importing countries helping to keep demand-pull inflation in check. More importantly, it reduces prices of imported goods. The second are the hedonic quality adjustments (HQA) the Labor Department uses to reflect the improving quality of the goods we buy. If the quality of an item increases faster than its price goes up, it can still register as a price decrease in the CPI calculation.

      Automobile prices are instructive. New automobiles are superior to those produced 20 years ago. They last longer, are safer, have more features and are more dependable. This is reflected in the increase in the median age of the US auto fleet. It rose from 8.7 years to 11.6 years, a 33% increase. In 1998, the average sedan sold for $18,700.00. Twenty years later, the average sedan sells for $23,100.00, an increase of 23.5%. However, because of the quality adjustment the price increase reflected in CPI is only 1.49%.

      The Bureau of Labor Statistics (BLS) makes these quality adjustments across a wide swath of goods including apparel, appliances, photographic equipment, telephones and televisions. Remember that these adjustments are mostly subjective. Is it reasonable to adjust a TV price lower to reflect the higher quality of its picture over a prior model? Or, to adjust a phone because its camera has 10 megapixel resolution compared to the prior model with 8 megapixel resolution? It costs as much or more to buy the better picture and higher resolution, but while pleasing, they add little to the quality of one's life. That said hedonic adjustments, while overused, mostly make sense.

      In direct contrast, the price of services has been rapidly rising over the last decade. This is important in that seventy percent of the US economy is service related. Services include items like rent, tuition, plumbing services, medical services and childcare. While you may occasionally purchase a new television, automobile or toaster you use the service economy constantly. Part of the reason is that services are difficult to import. This makes them far less subject to the forces of globalization than goods. You don't go overseas to get a haircut, to have your home plumbed, or your yard cared for.

      We expect that services, including housing will continue to push headline CPI inflation higher. At the same time, the trend to globalization is reversing. The combination should result in higher rates of inflation. We continue to make the case for opportunistically adding short-duration inflation hedges to investment portfolios. We currently view inflation assets as offering particularly good value given our expectations.

      Current Inflation: After peaking in the first quarter, inflation expectations (as measured by the TIPS markets) have declined sharply. The largest decline in breakevens occurred after import prices fell more than expected and the University of Michigan Consumer Expectations Index weakened. Core PCE, the Fed's preferred measure of inflation, has declined from 1.9% YOY in December to 1.6% YOY in April. Headline CPI, which accrues to TIPS, has moved slightly lower and is now up +1.8% YOY. The softening has mostly been driven by lower energy prices. Core CPI (excluding Food and Energy) is still running at 2%.