Is Inflation Hot Enough to Burn?

Recent levels of inflation bumped up against the danger zone but should cool off over the next several months, says Morningstar's Bob Johnson.

Bob Johnson: Great to be here. Stipp: First question for you, when we look at where we are with inflation right now--and we did see some inflation start to heat up earlier in the spring--can you put that into some context? How bad was the inflation that we saw compared to what we have seen historically over the last several decades? Johnson: Well, actually the number was fairly close to the long-term average, right now were running at about 3.4% inflation looking year-over-year; that is comparing this May with last May, which is the last set of data we had. Were up about 3.4%, and the historical average is about 3.5%--measuring from 1947 through the current time. So were running pretty close to what Id call normal. Stipp: Now, when people think about inflation, a lot of folks will think back to the 1970s1980s time. How does that 3.5%-3.4% number compared to the inflation that we saw during that high inflation period? Johnson: Well, thats a very interesting theme, because I did say the average, it was in mid 3%s, but a lot of that was driven by the period from 1970 through 1982, when ... oil prices tripled very quickly and when we had a very inflationary wartime type of economy going on, and we really got inflation spiking up there. So if you take that one period, ... from 1970 to 1982, where inflation didnt drop below 4%. So, that really inflates the overall period. Stipp: So, when you take that period out and look at the inflation rate, would you say that were a little bit on the high side then at the 3.4%? Johnson: Id say the 3.4% is a little high. I think we need to be somewh ere in the 2%-3% range to be what Id call normal. So, were clearly running ahead of that, I think driven a lot by food and energy. Stipp: So, lets talk a little bit about what some of forces are that are affecting inflation today.

There seem to be some countervailing forces. So, on one side we still have a high unemployment and what a lot of folks would say is slack capacity out there in the economy, which would tend to keep a lid on inflation. Yet we also saw inflation begin to spike. So, on the side th ats keeping inflation down, what are some of those factors and how effective have they been at keeping inflation from being even higher?
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Johnson: Well certainly, housing is one of the big things thats in the number. And it's not housing prices that go into the index. I want to be real careful about that. They use something called "owner equivalent rent." It's as if you rent your house. And certainly with all the foreclosures out there, rents arent exactly going through the roof, and so, thats kept a lid on inflation, and housing in general is about 40% of the index. So, that certainly helped keep a lid on things. And certainly the services side of the economy has been a little bit soft as well. But where youve seen high inflation is in food and energy and goods that are consumed from around the world, where the U.S. isnt the only thing setting the price. And, yes, while we're having our little slump here, keep in mind that India and China and Brazil are all countries growing probably in the 8% to 10% range. Stipp: So, we talked a little bit before about how, for example, when gas prices go up, well actually see consumers here in the U.S. start to pull back a little bit. Maybe they change their vacation plans. Weve seen that some of the alternative energy cars have become more popular. Is that enough, though, that self correction, to overcome the global forces, or is that [global] demand for energy just going to continue to overwhelm even what we can pull back here in the U.S.? Johnson: I think the U.S. is no longer setting the demand. I think it's really China thats setting demand, and as they continue to grow with these large rates, they are going to set the price of oil and gas, not the United States. And we could go to 20% unemployment and still have high gas prices, unfortunately, because of the demand in China. Stipp: So ... weve been talking about the CPI as the measure of inflation, and some folks would question whether thats a true measure of inflation. What are some of the factors that you would think about as an individual regarding whether your inflation might actually be higher than that CPI number? What is CPI capturing, and what is it not capturing so well?

Johnson: Well, it tries to capture an average balance for an average consumer, and of course, nobody is average. Youve got people, for example, that use a lot of medical care and a lot of drugs where prices have gone up substantially faster than CPI. And if you had [investments] indexed to the CPI, you would not be particularly well covered. Another area where weve had issues is education, which has grown much faster. College education has gone up much more quickly than the rate of inflation. So, those are couple of categories, and I think some tax categories in local government might also show some pretty strong inflation. On the other hand, on some of the housing-related things, youre probably spending less than you were a few years ago. I think people buying the same house that they could have bought five years ago, the mortgage payments on that house are probably two-thirds of what they're used to be, down a third. Stipp: And also with those folks, a lot of them probably preferring fixed rates if they can get them now. So, they probably wont have an inflation impact necessarily on that big cost of the household. Johnson: Absolutely. Stipp: So, I want to talk a little bit now about what you expect to be coming up, because it seems like we have seen inflation at least level off a bit here, because we had been much higher in gas and oil than we are right now. So, what are you expecting for the back half of the year, and why do you think inflation might continue to tail off a little bit? Johnson: ... So on a year-over-year basis, weve been running at 3.5% or so. I think in the back half of the year, well be between 1% and 2%. And we may even have a month or two where the number goes negative because of gasoline prices, for example. I think, the two big drivers have been food and energy, which are very real costs, which hurt the economy in a very real way, but I think those are going to come back in here. And on the food, it's based on new crops coming in, some better growing conditions, and we just had a perfect storm of negative things last year. So, I think food price inflation, even if you look at the Producer Price Index for food, it seems to indicate the consumer level is due for some price decreases in terms of food prices in the months ahead, so thats good. And weve already seen gasoline come back from $4 to

more like $3.60 gallon on average. So, weve seen some things moving in the right direction, and thats why I am optimistic. Stipp: So, when you are looking at the full year including some of the higher inflation in the first half and hopefully some less inflation in the second half, you are coming in around 3% inflation for the full year? Johnson: Yes. If we grow a tenth or two each month through the rest of the year, we should end up somewhere between 3% and 3.5% for the full year of 2011. Stipp: Now, weve talked before about how you keep a close eye on inflation, and youve called it the "recovery killer." So that 3% number, you said its a little on the high side compared to history, especially when you adjust for that 1970s-1980s period. Is 3% still in the danger zone for really hurting the recovery? How high would it have to get before you'd really start to get worried and say, "Hey, we cant sustain this. This is going to cause us to go into another recession?" Johnson: Were bumping up against being close. I think 4% or 5% is the magic number, but it's actually gotten out of hand more than that [in the past]. One of the things that surprised me going back: Out of the 10 recessions that weve had since World War II, there is really only one--the recession in 1961--that wasnt associated with a pretty decent spike in inflation. And I am not talking a small spike. We tend to think how bad this [recent] inflation has been--look how gas has gone up, how bad things are right now. I looked back, and in 1980, that recession, we had 14% inflation. In 1972, we had 12% inflation. Even in 1948, we had 9% inflation. So, all of these recessions are associated with the spike, and like I say, most of the time that spike is over 4% and usually over 5%. So clearly, weve got a little bit of room left in here, but I'd hate to use that last bit of space up. Stipp: At the very least it's probably going to cause the recovery to be a little bit slower at that 3% inflation rate, even if it doesnt cause us to dip into another downturn. Johnson: Exactly. Stipp: So last question for you Bob: A lot of attention has been paid to the government intervention, the government actions that we saw throughout the downturn, and folks are concerned that that could cause rampant inflation in the future. Whats your take on government policy and how worried should we be about it?

Johnson: I think all of us, especially, those who grew up in the '70s, were afraid... you know, you had all this money supply, these low interest rates that were just building things up for an eventual, really large pop in inflation. And Ive become a little bit less concerned about that. I think that there are more checks and balances on the system this time. The spike that we saw in the 1970s, so many of the wages were tied to union contracts, where you got a cost-of-living, maybe even a cost-of-living-plus [adjustment]. So, if you had a 6% gasoline price increase, your wages went up 6%. Maybe you had a month or two of delay, but you generally got compensated for inflation. So, that made people less concerned about it, and thats why we had that kind of 12-year bout, if you will, with inflation. And I think now we havent got that so-called transmission mechanism. If the price of gasoline goes up, then we stop spending on something else, and that tends to cool things down a little bit. Stipp: All right, Bob. Well, thanks for your insights on inflation, your forecast, and for joining me today. Johnson: Thanks. Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.