Is CPI Inflation Really Coming Down? Four Reasons To Be Worried About The Next Ten Years

The bond market is guessing that inflation will average 2.2%. Is this foolish?

Today’s CPI number will be not too horrible. Moreover, the bond market is telling us that inflation is about to dramatically recede. Bond prices imply that inflation over the next decade will average a very subdued 2.2%.

The bond market might be right. It might be very wrong, in which case people who buy long-term bonds with meager nominal yields will end up poor. Here I explore four reasons why the Consumer Price Index could deliver unpleasant surprises for bond buyers in coming years.

#1. China Syndrome

So far in this century, great downward pressure on the prices of manufactured goods has come from China. In the next decade, however, that positive influence on our cost of living is likely to be reduced or even reversed.

One reason for a reversal: Even with the end of strict lockdowns, China is coping badly with Covid. Another matter is that the emperor, Xi Jinping, seems to be on the warpath against entrepreneurs. A third problem is that the country is exhausting its supply of cheap factory labor as the rural poor move into the middle class.

Apple is having some hiccups with manufacturing in Zhengzhou. When the dust settles on its assembly lines, the iPhone will kick the CPI higher.

#2. Understaffing

The sign on the restaurant door says: Apologies for longer wait times. We have a staff shortage.

But the restaurant has the economics wrong. There is no staff shortage anywhere. There is only a shortage of employers willing to pay a market-clearing wage.

This is what that restaurant has to do: Raise wages 30% and raise menu prices 30%. That will increase the supply of workers and decrease the demand for meals away from home. Supply will meet demand.

Wages are sticky. They take a while to come into equilibrium with changes in supply and demand. Eventually, they come into equilibrium. As that happens over the next three years, the CPI will be pushed up.

#3. Home Prices

The Bureau of Labor Statistics tries to account for the cost of home ownership via a metric it calls “owner equivalent rent.” That owner rent figure matters a lot. It gets a 30% weight in the CPI.

The owner rent figure does a poor job of revealing the rise in living costs. This will give you a sense of how the metric has gotten out of alignment with reality: Over the past 35 years home prices have just about quintupled, yet the owner-rent number used by BLS has merely tripled.

It must be admitted that connecting a home price to its rental value is not a simple task. Long ago, the BLS used mortgage payments as its starting point. But the run-up in interest rates in the early 1980s made gibberish out of that calculation. That’s because the number crunchers were, by inspecting bank mortgages, looking at nominal rates when they should have been looking at real rates (nominal minus inflation). The BLS economists were also troubled by the fact that home prices reflect both rental values, which should drive the CPI, and a speculative element, which should not.

The BLS tossed out the old mortgage payment approach and settled on a complicated formula that aims to extrapolate changes in the rental value of single-family homes from changes in the rents quoted on apartments. This doesn’t really work. The apartment market, mostly urban, is very different from the detached-home market, mostly suburban.

Someday the BLS will come to its senses with a formula that starts with the price of those suburban homes. The price could be some version of the Case-Shiller home price index, smoothed to take out speculative booms and busts. In case you are wondering, Case-Shiller, the source of that 5x statistic quoted above, duly adjusts for changes in home quality over the years (more bedrooms, more air conditioning).

Next, multiply the price level by a percentage cost. That percentage would be the sum of a real interest rate, a property tax rate and a maintenance and repair rate.

Those three percentage components are probably all going to be rising in coming years. The real interest rate, as measured by the yield on 30-year Treasury inflation-adjusted bonds, has shot up 1.6 percentage points in the past 12 months. Property taxes will get upward pressure from the shortfalls in municipal pension funds. The cost of getting someone up on your roof to replace the shingles will go up (see #2, Understaffing).

Here’s what you get: A rising home price level, multiplied by a probably rising percentage number, delivering an upward push to a big chunk of core inflation.

#4. History Lessons

Not too long ago the Federal Reserve was saying that inflation was “transitory.” The Fed has stopped using that word, but bond investors are still mesmerized by the notion that the 8% to 9% inflation rates seen over the summer were just a blip that will quickly go away.

Compare the yield on nominal ten-year Treasury bonds (3.6%) with the yield on ten-year inflation-protected Treasurys (1.3%), and allow something like 0.1% for the risk premium built into the former number. The bond market seems to be saying that it expects annual inflation to average 2.2% or so between now and the end of 2032.

It’s possible that inflation will rapidly recede, as the market expects. Possible but unlikely, if history is a guide.

Robert Arnott, the astute proponent of value investing at Research Affiliates, published an essay a month ago in which he reviewed inflation surges over the past 52 years in 14 developed economies. Here’s his grim summary: “Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.”

Fair warning to anyone who owns one of those nominal bonds presuming a 2.2% inflation rate: You might be vindicated. But the odds are against you.