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Inflation Nation

June 11, 2018 / Jonathan Holtaway and Jacques Rebibo

Price level surveys play a central role in monetary policy and government budgets.  Our modern CPI, or Consumer Price Index, was formulated in the 1970s, but the US government has been doing price surveys for over one hundred years.  It’s become common for journalists to equate the rate of change in the CPI with the inflation rate for the economy.  But is it?

If you unpack that shorthand assumption a little, you will find that the use of price surveys by the government is a contentious subject.  Price studies were used to set wage rates for shipbuilding trades in World War I and steelworkers in World War II.  At the time methodology was heavily scrutinized by the interested parties, whose income was directly affected.  The items and geographic regions included in a price survey influence the outcome.  Over long periods of time or during periods of rapid price movement, the CPI can literally make or break policy.  It is not coincidence that modern CPI was formulated in the 1970s, a period of high inflation, when the stakes for “getting it right” were high.

Based on the CPI, the last decade has been a period of low inflation.  After nine years of economic expansion, CPI is nudging only 2% annually, which is a mandated target of the Federal Reserve’s monetary policy.  Low inflation and even the risk of deflation has been a worry of economists for ten years.  What if this view isn’t quite right?

Everyone is familiar with products and services where CPI doesn’t seem an appropriate measure, such as the cost to go to college.  Twenty-five years ago many states created prepaid tuition plans to allow families to pay for their children to go to college years before they matriculated.  The plans were sold appropriately as a way to overcome college tuition inflation.  Too appropriate, in fact, because many of the plans got into trouble when states couldn’t get enough return on the prepaid money to offset higher costs.  College inflation is greater than the time value of money, or put another way, having enough money to pay for college today does not assure you will have enough in five years, a classic inflationary conundrum.

There are other major markets with consistent, above CPI inflation.  Medical insurance is a good example.  Small business medical plan costs have compounded at rates above 10% for many years.  Food prices are another inflation conundrum.  Agribusiness and fast food are incredibly efficient, but a perception of health problems stemming from corporate food practices has led to burgeoning markets for organic meats and produce.  Alternative food categories are expensive and inflating.  The sales of traditional supermarket, Safeway, in 2014 for $10 billion to Albertsons, and smaller Whole Foods in 2017 for $14 billion to Amazon underline the duality of food prices.  Which food reality does CPI capture?

Our feeling, and we are not economists, is that CPI is probably accurate for short periods like a year or two, but over long periods like ten years, an accumulation of small, compounding errors, changes in consumer habits and geographic differences open CPI to missing the mark.  Ten years of 1% annual CPI growth does not necessarily mean the compounded product, or a 10.4% change in price level, has occurred for the full period for the full economy.  Errors and consumption pattern change open the possibility for maybe a 5% or 20% change having occurred, particularly for different segments of consumers.

Monetary policy for the last ten years has been extremely loose including the use of quantitative easing.  This is because supporting employment has been the driver of monetary policy.  Low CPI has served as the evidence that loose monetary policy has not been inflationary.  But what if this isn’t quite right, and there has been outsized inflation, just not captured in CPI.  We have already discussed food, medical insurance and college.  What about the sector at the center of the last recession, housing?

Like food, housing is an inflation duality.  Declining mortgage interest rates helped those with equity and income to refinance and lower their monthly payments.  However, sustained low rates have now led to ever higher prices in dynamic markets like San Francisco, Seattle and Washington, D.C.  Higher prices have brought higher taxes, higher insurance and higher transaction costs, which eats up the cash flow advantage of lower rates.  A millennial worker newly employed in a hot market can buy half the house a Generation X worker could fifteen years ago, even though CPI doesn’t indicate such a change has occurred.

Taken together housing, medical insurance, premium food and college are the assets and services that define the upper middle class.  Whatever the cost, you are not in the upper middle class if you and/or your kids don’t have them.  The change in price level for these high dollar categories has fundamentally altered consumption ratios by the upper middle class in terms of where their dollars go.  It has also made these items unaffordable for the wage earning middle class, making it a primary source of economic divide in the US.  But how do you relate inflation in these critical, large dollar categories to monetary policy?

College tuition can be neatly placed into this.  In 1990 Ivy League schools matriculated about the same number of freshmen as they do today.  Over the same period the US population has increased 33%, the upper middle class has doubled in size and Ivy League universities have increased the percentage of slots given to international students.  A larger pool of students vying for the same number of spots has led to admission rates plunging from 15% in 2007 to 7% in 2018.

Tuition inflation has less to do with increased cost than supply constraint.  This can be generalized to all well branded US Universities, which have done everything possible to utilize their embarrassment of riches, except the obvious, increase enrollment size.  The result is the US turns out the same number of “branded” college graduates as 30 years ago, but at triple the cost.

Monetary policy has fanned the flames of a zero-sum game in college admissions by arming the upper middle class with cheap borrowed money and supporting the super wealthy, who have helped build massive college endowments.  Tax deductible donations and tax-free investment returns have led to the incomprehensible fact that the annual tax deduction available to the Harvard Endowment is enough to give 3,000 students a year a free ride at Harvard.  A system of low productivity and high inflation is being subsidized by tax breaks.

The story is different for medical costs, but the outcome of inflation is the same.  Medical insurance in the United States is not a market, it is a binary question, either you have it or you don’t.   Since the nineties, though, medical insurance has been transformed by a greater number of drugs and therapies, a broadening of access beyond the stable working population and the declining health of the pre-65 population due to obesity.  Medical insurance Inflation is about a dramatic uptick in demand and use of services, including newer services and drugs that tend to be very expensive.

Financing medical inflation is a patchwork made affordable mostly by low interest rates.  The drug benefit expansion in the Bush Administration, the Obamacare subsidies and the Medicaid expansions from the post-recession stimulus bills are all being financed by the federal government.  Low rates play a critical role in the Federal government’s ability to fund its commitments.  In the private sector where cheap borrowing is not easily available, it is being borne primarily by workers, whose direct pay is not rising, even as the total cost of having an employee is inflating for businesses.

Medical insurance, housing, college and food are pretty much the bedrock choices of upper middle class consumption.  Without adequate supply, housing in hot markets and college tuition look very much like zero sum competition causing inflation, which is being supercharged by low rates.  Food and medical insurance look like market breakdowns, or more simply, bad policy choices.

This week the Federal Reserve holds one of its regular monetary policy meetings, and at the conclusion of the meeting, short term interest rates will be increased by 25 basis points.  Policy makers will speak of maintaining a balance between supporting employment while maintaining inflation near their 2% target, and recent CPI results will show their balancing act as successful.

Our concern is that inflation has a substantial hold on major segments of the economy and at rates well above those measured by CPI.  Further, the problem is not just a matter of monetary policy, but is structural both in how markets are functioning (college, medical and housing) and how services are being funded (federal budget).  There is an old saying that history doesn’t repeat, but frequently it rhymes.  Markets have grown accustomed to fleeing to the safety of US government debt whenever there is crisis in the world, thus bringing down US interest rates and stimulating the US economy.  History shows that the US is not immune from structural crisis that can cause US interest rates to rise, not fall.

Jonathan Holtaway

Jonathan Holtaway

Jon Holtaway is an expert in the banking sector and has been quoted in national publications such as The Wall Street Journal, The Financial Times and The Washington Post. As a hedge fund manager and former investment banker, he has dedicated his career to investment analysis and building relationships in the banking sector. After spending twelve years with a premier regional investment house, Jon has co-founded two companies and has extensive experience working with wealth management and residential mortgage companies. Jon serves on the board of a publicly-listed community bank holding company, Hawthorn Bancshares ("HWBK"). In his free time, he is a passionate reader and writer. He authored “The Growth Penalty: Unfinished Business, Banking and the American Recovery” in 2013.

Jacques Rebibo

Jacques Rebibo

Mr. Rebibo has been a community bank investor for over 30 years. He entered the banking industry in 1985 when he invested in and joined the board of a de novo bank, Fairfax Bank & Trust. In 1999, Mr. Rebibo was an organizing director and subsequently became Chairman for nine years of Access National Bank, which grew to $3 billion assets before selling in 2018. In 2009, Mr. Rebibo co-founded and was Chairman of 1st Portfolio Holding Corporation, a residential mortgage and wealth management company. 1st Portfolio was sold to WashingtonFirst Bankshares, “WFBI” in 2015.