Devil in the details of U.S. inflation report

Headline inflation seemed tame, but some of the underlying data, including rent and services inflation, are truly worrisome.

Robert Johnson, CFA 22 February, 2016 | 6:00PM

Markets were generally stronger this week, though we are at a loss to explain why. Almost every major equity market was up about 3%. Commodities were just about flat, and oil seems to have stabilized, at least for this week, with more talk of oil production curbs by major producing nations. We aren't great believers in this actually happening. We do believe that, based on production costs and demand that continues to grow, oil prices may not have a lot further to fall. However, we don't hold ourselves out as experts in this area.

We would guess that talks about more monetary easing combined with stabilization in oil prices and acceptable, if not thrilling, economic news kept markets happy. Modestly lower bond yields this week suggest that more QE is anticipated. But maybe the sellers just got tired, too. No one knows.

Most of the economic data needed a fair amount of massaging to make much sense, so we will leave most of the details for later. However, the first uptick in industrial production since July had to be viewed as good news. Housing data was the most muddled, but growth in this key sector appears to be neither accelerating nor decelerating. Headline inflation seemed tame at 0%, but some of the underlying data, including 3% growth in services inflation and a 3.7% increase in rents, is truly worrisome. If it doesn't change direction shortly, the inflation data may force the Fed's hand, perhaps as early as the March meeting.

Headline inflation surprises to the upside; details even worse

Headline CPI was expected to decline 0.1% month to month in January. Instead, prices were unchanged. The news on core inflation (excluding food and energy) was even worse, with a 0.3% increase versus expectations of just 0.1% inflation. Even single-month year-over-year data looked to be heating up, as headline inflation was up 1.3% and core inflation was up 2.2% year over year. Our year-over-year averaged data looks slightly less problematic, but only because of a really low inflation number for December.

The longer-term year-over-year averaged growth, below, shows the budding problem as energy prices begin to stabilize. Single-month annual core inflation, at 2.2%, is now at the highest point of the entire recovery and likely to worsen as labour markets continue to tighten.

Splitting inflation into its component parts also shows building pressures. Energy deflation continues to diminish as we lap some of the bigger declines (although we are likely to get a reprieve in energy prices in February and maybe March because of the huge swoon in gasoline prices in early February of this year and a temporary run-up in prices in spring 2015). As the dollar stabilizes, goods deflation is no longer accelerating, either. Meanwhile, services inflation continues reaching a single-month recovery of 3% in January.

So on the inflation front, the Fed may get its wish for 2% inflation granted by midyear 2016 if current trends persist. Only slow increases in food prices are showing lower inflationary trends.

The individual category data was very depressing for consumers. The January data seemed unusually bad, perhaps because of first-of-the-year price increases. You know it's bad when the slowest gainers analysis (when all of energy is lumped in one bucket) almost overlaps the fastest gainers. There was a huge pile-up of categories at 0.3%.

All of our nemeses--drugs, healthcare services, and rents--had a bad month. The rent category by itself was up 0.3% month to month and a stunning 3.7% year over year. No wonder non-driving city dwellers are claiming reported deflation is a mirage. And a normally sanguine clothing sector exploded after months of declines, as winter weather returned with a vengeance and retailers didn't have to offer big seasonal discounts on winter coats (the price of women's coats jumped 7% month to month).

Like we said earlier, only the trends in grocery prices and vehicles are looking favourable to consumers. And perhaps there is some hope that the big jumps in healthcare in January will level off for a few months, as they often do. And maybe the unusually big jump in overcoat prices in January will disappear in February. But that's not much for the Fed or our team to hang our hats on.

Retail sales growth nothing special after adjusting for goods inflation in January and deflation in December

Unfortunately, there isn't enough time this week to do the full analysis of adjusting retail sales data category-by-category like we did last month. We have said the retail sales data is close to useless without at least some inflation adjustment. Last month, we noted that deflation made retail sales look a lot worse than they were. Excluding gas and auto, retail shrank by 0.1%, but we needed to add back at least a couple of tenths because of deflation. Now the December figure was revised up to 0.1% growth. With a deflation add-back of about 0.1%, retail ex-auto and gasoline sales grew about 0.2% in December. Now, the January retail sales number looked great at 0.4%, but adjusted for inflation of roughly 0.2%, that real sales growth was 0.2% yet again, and not the dramatic improvement that everyone talked about just one week ago.

Manufacturing no longer the disaster that everyone was expecting

For months we have been claiming that we saw serious signs of stabilization in a lot of the manufacturing data while most of the pundits were ranting and raving about a strong dollar and slow growth overseas destroying the manufacturing sector. We finally got some vindication with this week's industrial production data, especially in the manufacturing-only data.

Of course, some of the current industrial production headlines were over the top in the other direction, including "the first increase in IP since July," or "the 0.9% growth rate in January crushes estimates of just 0.3% growth." However, we would curb a little of that enthusiasm, as year-over-year total IP was still down 0.7%, and utilities (about 10% of the index) jumped 5.4% as weather returned to more normal levels. And even the struggling mining and oil production data managed to lurch back to the flat line after many months of declines. Year-over-year data, not shown, indicates for the single month of January utilities were off 2.8%, mining was off 9.8%, and manufacturing was up 1.2%. Clearly, mining and utilities have been weighing on the headline numbers for some time.

Now let's return to the manufacturing data only and compare fourth quarter to fourth quarter data annual to detect any underlying trends.

This data suggests that overall manufacturing data, other than a below par, early recovery bounce, has been nothing special compared with long-term averages of about 2.3% growth. And if anything, it is the big bump in IP manufacturing growth in 2014 to 3.4% that looks like the outlier, and not the 1% growth in 2015. The growth in 2014 was quite narrow. Much of it was concentrated in just two categories (chemicals and machinery), accounting for two thirds of the improvement. Growth almost everywhere else was lacklustre, nonexistent, or was too small a category to make a difference in 2014.

Those same two categories also dominated the 2015 data, except this time in reverse. Machinery moved from 8% growth to 4% shrinkage. A lot of problem children dominate this category, including agricultural equipment (poor crop prices), construction equipment (less foreign activity), and mining (poor commodity cycle in the U.S. and around the world). Chemicals still grew in 2015 but at a slower 2% pace instead of 4% in 2014.

So with that historical context, now we can examine some of the sequential growth numbers that looked so good. It was a great month for the top three categories that constitute about 40% of the index. Those gains erased some relatively pathetic December data for the big three. And the auto sector, which ruined a lot of December and fourth-quarter data sets, had a very nice January bounce that entirely offset the flaky December decline of 2.8% sequentially.

While the market was quite excited by the strong sequential data, these numbers are highly volatile and often have great months followed by poor months. We think manufacturing, overall, will see growth acceleration from 1.0% in 2015 to 2.0%-2.5% in 2016, as machinery declines burn off and food growth accelerates because of lower input prices. (Our IP manufacturing forecast equates to about 0.2% per month, to help put this month's 0.5% gain in perspective.) We will take the quick start to 2016 but caution that monthly growth this high is not sustainable.

Housing data shows not much is changing in either direction

Although headline sequential data suggests the housing market might be softening again, a deeper look at the data does not support some of the glum assessments we have read.

Turning first to the headline numbers, builder sentiment dropped from 60 in January to 58, hardly a catastrophic fall. Second, housing starts looked surprisingly weak, dropping 3.8% sequentially to 1.1 million annualized units in January. Based on strong permit data over the past several months, there was hope that starts would show a healthy increase to 1.14 million units. We warned last week that the hope for a strong month of starts in January seemed to be a bit of wishful thinking. December was unusually warm and dry, and January wasn't quite as off-the-charts warm and was much stormier. We also warned that the starts numbers in the winter months aren't nearly as important as the spring months when starts can be as much as 50% higher than the winter months, before seasonal adjustments. Total permits were flat month to month, again not delighting analysts. This is why many analysts are claiming this was a bad month for housing data.

However, on the bright side, the level of permits remains elevated relative to starts. In fact, total permits, at just over just 1.2 million annualized units, was more than 100,000 units and 10% above housing starts. That is good news for future construction because permits have to be filed before construction can begin. And because of the fees involved, decisions to file permits are not made lightly. So the likelihood is high that strong permit data will turn up in future months. We have said many times that we prefer looking at the permits data because it is less affected by weather, timing, and measurement issues (government officials pull a limited number of permits, then actually visit the site to see if construction has begun and a start is recorded). Total permits are near their recovery-high levels with the exception of the May and June data that benefited from allegedly expiring tax credits in New York.

We also tend to focus on the less volatile single-family home market to remove some of the noise from the data set. Confidence intervals provided by the government suggest that permit data is highly reliable and extremely close to reality. Starts data, however, has an off-the-charts confidence interval that makes it hard to tell if even the sign on the month-to-month growth rate is correct. Also, although single-family permits account for roughly two thirds of starts and permits data, they currently account for 80% of nominal residential new home construction.

The pattern in single-family construction remains relatively clear. Both starts and permits growth have converged to growth rates in the 7%-9% range. This would be extremely consistent with overall total housing starts growth of 8% in 2016 (down slightly from 10.7% in 2015), from 1.11 million units to 1.20 million units. So we really aren't expecting much change in growth rates in 2016, with maybe just a little upside potential if the backlog of permitted but not started multifamily units begins to clear (there were just 54,000 unstarted multifamily homes in January 2015 and now there are 83,000). No boom and no bust for housing.

Builder sentiment still healthy despite land and labour shortages

Given some context, we wouldn't worry too much about builder sentiment data that slipped modestly in February, from 60 to 58. Though the data has trended down some recently, the current reading is still above February 2015 levels, and above levels of last spring and fall. Given the stock market volatility of late and the December increase in the Fed funds rate, some back-off was to be expected. Also, from a business perspective, builders are facing land shortages in key markets as well as ongoing labour shortages partially offset by cheaper raw materials.

Even in this data set, there was some positive news in one of the three components. The prospects for better business six months out increased from 64 to 65. We suppose this component is more an opinion, but it is the most forward-looking of the three components. Both actual traffic, which is hard to fudge, and current conditions did slip on a January-to-February basis, however. For both of the first two months of 2016, the outlook and current conditions were above year-ago levels while traffic was unchanged from last January and February levels. So perhaps the new home market will be stronger than last spring, but not quite as robust as some of the strong summer and early fall months. In any case, like a lot of housing data, no major change seems to be in the works.

Next week brings Markit Flash PMI, housing, durable goods, gdp, and personal income and spending (by Roland Czerniawski)

Next week is likely to be an action-packed affair with a lot of key economic releases. First, Markit flash PMIs will be released on Monday, giving us a preview of how the U.S. and Europe's manufacturing sectors did in February. It will be interesting to see if stronger U.S. manufacturing results in January brightened the sentiment among purchasing managers.

On Tuesday, Case-Shiller home prices and existing-home sales will be released. Home-price increases had been accelerating in the fourth quarter of 2015. Given continued low inventory levels, it is likely that this upward price growth trend might hold well into the first quarter of 2016. On the sales side, existing homes have experienced a solid rebound in December after a sharp decline in November. Consensus calls for 5.4 million annualized units, which would keep home sales flat from the already-high December level. Given relatively flat pending sales data, 5.4 million units sounds optimistic, but month-to-month pendings and existings are not always perfectly correlated. In addition to sales, inventories will be a key metric to watch, as the year-over-year trend in existing-home inventory growth has been negative for seven consecutive months. Without more homes to physically sell, 2016 could prove to be a tough year for existing-home sales to show much growth at all. New home sales should do better given higher inventory levels.

On Wednesday, focus will remain on housing as the U.S. Census Bureau will publish new home sales data. The December reading skyrocketed to 544,000 units, which was the highest level since 2008. The new homes market appears to be doing very well. Despite high demand and good sales, inventory levels continue to grow, showing a high level of confidence among builders. We expect this upward trend in new home sales to hold, although a modest pullback in January should be expected as December results were probably unsustainably strong. Consensus calls for 528,000 units, but our readers should be aware that new home sales data is, by nature, a volatile metric with a relatively large margin of error.

Durable goods orders will be published on Thursday, with consensus calling for a 3.3% increase following the 5.0% slump last month. Durables are notoriously difficult to predict, and we will be watching the data closely, along with the markets.

Finally, on Friday, GDP and personal income data will come out. The second GDP reading will be particularly interesting as the first reading showed a muted 0.7% growth rate in the fourth quarter. The consensus calls for a downward revision of GDP on the second reading to 0.3%0.5% due to lower-than-originally estimated construction spending. At the same time, the highly unpredictable inventory category could offset some of those losses. In either case, a lower fourth-quarter GDP reading is not a reason for panic, as we've seen considerable improvements in the first quarter already, and some of the losses in construction and inventories will most likely reverse in first-quarter 2016.

On the personal income and spending side, there are reasons to believe that it will be a strong release. A sizable rebound in utilities consumption and motor vehicle sales indicates a much better consumption picture going into 2016. The swing in utilities alone could add 0.2% to consumption growth, and autos should be good for at least another 0.1% swing. That's already well on the way to the consensus estimate without help from much of anything else. Consensus calls for a 0.4% increase in income and a 0.4% increase in spending. Besides stronger incomes, there is a possibility that consumers might finally tap into their savings, which have been rising steadily throughout the second half of 2015. This offers the potential for further upside for consumption.

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Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.