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By Robert Johnson, CFA and Jeremy Glaser | 03-15-2017 03:00 PM

Inflation Not in Danger Zone

Morningstar's Bob Johnson sees signs that year-over-year inflation growth is peaking, but a shock could quickly boost prices and threaten growth.

Jeremy Glaser: From Morningstar, I'm Jeremy Glaser. The Fed has raised rates, but we still have questions about what the state of the economy is. I'm here with Bob Johnson, our director of economic analysis, to look at some recent data.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: Wednesday was a big day with the Fed meeting, but we also had retail sales and consumer price index, two very important pieces of data. Let's start with retail sales. You think these actually were somewhat disappointing.

Johnson: I do. The headline month-to-month number certainly was. We were only up a tenth of a percent on the headline number. That was clearly a very low number compared to what we had the prior month. It looks like the January number was overstated and this one's probably understated. You probably need to average the two to get to somewhere near normal.

Glaser: Let's look at those averages, then. I know you like to look at things year over year. Where are we, in terms of retail growth, and how does that compare to other parts of the recovery?

Johnson: Yep. I think that's a fascinating question. I think in the last six months or so, we've moved up a little bit, in terms of inflation adjusted retail sales growth from something that's 3.6, 3.7% to something that's a little bit over 4%. We've gotten a little better over the last six months. If you look at the full context of the recovery since 2010, we went through a block of time, 2010 through 2014, when businesses still really had the upper hand. Consumer wages weren't growing as much. Consumers were still running a little bit scared. Didn't have any housing assets to tap into. Retail sales growth for that early part, the first four years of the recovery, was probably averaging around 3%. From that time on, we've averaged a little bit more like 4%, in the range of 3.5 to 4.5, and right now, we're at about 4.1%. Clearly not barn-burners, not accelerating, but not really getting any worse, either.

Glaser: What do you think is potentially keeping that from being even better? What's holding back the consumer?

Johnson: I think the number-one thing is that inflation is heated up a bit. I think we can talk about the CPI report, but what's happened is that wage growth, it looks nice. It's 2.5%, but it's been that for a while. Maybe it creeps up to 2.7 one month and back down to 2.5, but inflation has gone up from practically zero, a couple of years ago, to something like 2.8% on a headline basis.

That same 2.5% wage growth doesn't go nearly as far as it used to. I think that's the problem with the economy right now. The consumer is 70% of that economy. That's why I'm concerned. That combination of relatively higher, but not horrible, inflation with wage growth doesn't seem to be going anywhere fast.

Glaser: In the short term, there's some problems with when tax refunds are getting paid.

Johnson: Absolutely. That was certainly in the month-to-month data, why we saw such poor growth in the February period. This year, instead of mailing out checks usually they begin around Feb. 1--the refund checks from the IRS, along with the earned income credits--and instead they went out on March 15, so they could do matching. So they could look at W-2s versus the top filed tax returns. That slowed things down at a minimum, maybe even eliminated some of the payments permanently as some fraud was avoided.

This year, there was about $20 billion less in consumers' hands than a year ago because of slower tax refunds. Clearly, that was part of the issue of February and why a lot of analysts are kind of saying, well, maybe we'll skip looking at the February data. I think you run the February and January number data together on retail sales and I think you get a number that's much more representative.

Glaser: Let's turn to CPI. What's happening with inflation? Any signs that we've peaked?

Johnson: Absolutely. We've got some good news there. First, let me start with the bad news part of it. The headline inflation rate was 2.8%, single month to single month, year over year. That's up from about 2.5%. That's moved up and three-month average may move up for one more month yet, but the single point has probably peaked in here. The reason is that it looks like gasoline prices for the month of March will be down sharply. I think that will begin to affect the numbers. I think that will hold back and cause the year-over-year inflation to have peaked sooner than I expected.

So, 2.8%, if everything else stays in relatively the same range, we could be down under 2.5% in the next couple months. Maybe under that 2.5% by the end of the year, in terms of inflation.

Glaser: What does services inflation look like? I know that was a concern for you for a long time.

Johnson: Well, you know, it still is. We've got 3.1% services inflation and it's been the same number for the last 12 months. Last February was also 3.1%. That's 60% of the CPI calculation, so clearly an important factor. It's not getting better, but it's not getting any worse, either, which comes as a little bit of a surprise.

It's probably because the wage growth isn't going up as much as we all feared. That's certainly held back some of that inflation.

We've seen some other categories--food has gotten a little bit better from a year ago. Last year, we had some food inflation. This year, on the year-over-year basis, there was no inflation. That's certainly been helpful to consumers, but that number may actually creep back up the other way. On the good side, again we've seen small declines in prices because a lot of our goods are imported. A strong dollar's helped kind of keep those prices leveled out.

Energy, of course, is the big flip going from huge decreases to huge increases, in the course of a single year, from minus 12 to plus 12. That's 7% of the CPI. I think those will flatten out here in the next couple of months.

Glaser: But short of big shock, it seems like inflation, if not tame, is still mostly under control.

Johnson: It certainly looks like that to me. I'm not saying that it's wonderful. When you're tumbling around this kind of core inflation rate of 2.5% and you get an oil shock or you get a crop failure or something that moves things in a big hurry, it doesn't make any difference if it's a special event. It's still going to wreck the economy and still cause consumer spending to go down if we have this quick spurt of inflation from any of those factors. 

So, it isn't so much that this number's a disaster, at 2 to 2.5%, closer to 2.5, but the problem is that we're close enough so that some small thing happening could push us closer to 4, which is disaster time. We're getting--CPI inflation, at any point, month over month, 4% and it's all over.

Glaser: Bob, thanks for your take today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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