If you are like me, there are some commercials that are not only repetitive, but just plain annoying, including the self-promotion ads one hears on the radio for specific stations. There is one in particular, aired by one of my favourite business stations, which has become like scratching nails on a chalkboard. It has a clip of one of the on-air personalities exclaiming that “the economy is not the stock market; the stock market is not the economy”. Sometimes you just trip over truisms in this business. Of course, the economy is not the stock market, though it does play an important role in determining the valuation of stocks. And, while the stock market is not the economy, it can affect things like demand and output through transmissions known as the wealth effect and its impact on general levels of business and consumer sentiment. There is also an even stronger linkage between the two “universes” and that is inflation. Today, we are at a crossroads, where the observable threats from higher inflation are being played down by utilizing statistical measures that attempt to diminish these threats. Welcome to the world of exclusion delusion.

Higher prices for the goods and services we consume is something that mankind has dealt with since the beginning. Other than those relatively brief moments in history where the general level of prices fell, inflation has been as certain as death and taxes. But why is this certainty so worrisome and why have central banks spent the greater part of the last half-century wrestling with it? In a nutshell, inflation is a dual threat. It acts as a 'hidden tax' that erodes consumer purchasing power and corporate margins, while simultaneously forcing a revaluation of all financial assets by driving up the discount rates used to price future cash flows. Simply put, it makes today's debt more expensive to service and tomorrow's profits less valuable to own.

As the above chart shows, US consumer price (CPI) inflation has already started to move higher and reached 3.25% in March. Note, the break in the chart reflects the government shutdown last year and the fact that the Bureau of Labor Statistics didn’t conduct surveys during that time. The 0.9 jump in the CPI on the month was driven by more than an 11% rise in energy prices – something that was fully expected in the wake of the Iran war. There are five key areas of the consumer basket that are impacted by higher energy costs.

1. Transportation Services (Specifically Airfare & Freight)

This is the most direct link. Jet fuel is typically the single largest variable cost for airlines.

• The Bleed: Beyond passenger travel, this includes "delivery and shipping" surcharges for every consumer good. When oil spikes, the cost of moving a TV from a port to a warehouse jumps almost instantly.

2. Food at Home (The Grocery Basket)

Oil is embedded in the entire food lifecycle.

• Production: Natural gas is the primary input for nitrogen-based fertilizers.

• Harvesting: Diesel fuels the tractors and combines.

• Packaging: Most plastic packaging is a petroleum byproduct (petrochemicals).

• The Bleed: This is why you see "Core Food" stay high even after energy prices stabilize; the harvest cycle has a long memory.

3. Household Energy / Utilities

While gasoline is the headline-grabber, heating oil and the natural gas used for electricity generation are massive components of the housing category.

• The Bleed: This is particularly "sticky" inflation because consumers can’t opt-out of heating and cooling their homes or keeping the lights on, which drains discretionary income for other sectors.

4. Apparel & Synthetic Textiles

A huge portion of modern clothing—polyester, nylon, acrylic, and spandex—is made from petroleum-derived synthetic fibers.

• The Bleed: When oil prices stay elevated, the raw material cost for the textile industry rises. Because apparel has a long lead time, this inflation often shows up on retail racks 6–9 months after the initial oil spike.

5. Medical Supplies & Pharmaceuticals

This is the "hidden" oil category. From plastic syringes and IV bags to the chemical reagents used in drug manufacturing, the medical sector is heavily reliant on petrochemicals.

• The Bleed: Because medical demand is "inelastic" (people need their medicine regardless of price), this is an area where companies have significant pricing power to pass those energy costs directly to the consumer or insurer.

Let’s also keep in mind that these influences from the Iran war are in addition to inflationary pressures coming from the continued massive investment in the artificial intelligence (AI) infrastructure. Think of powering and cooling data centers.

Still, we see many stock indexes hitting new highs amidst extremely positive corporate financial results. Some analysts claim that because the US economy isn’t as energy dependent as it was back during the OPEC crisis days of the 1970s, “things are different”. That also lines up with an approach to viewing inflation that would strip out things like sharply higher energy costs. We have the most common measure of prices – the Consumer Price Index, or CPI. We can then exclude energy to arrive at a CPI ex energy measure. If we take out food prices, we have the most common version of a “core” CPI measure.

We are about to see the confirmation of the next Federal Reserve Chair – Kevin Warsh – and he is an advocate of another version of CPI which is called the “trimmed mean”. This measure was pioneered by the Dallas and Cleveland Federal Reserve districts and was designed to identify the signal that consumer prices were telling us by stripping out the noise. Essentially this measure discards items in the CPI basket that are at the far ends of the price-change spectrum. The theory is that large one-off price increases (for example, in oil or gasoline) do not represent a long-term trend and should not be a factor when it comes to looking at inflation through a monetary policy lens. In the case of the Cleveland Fed, they trim the top 8% and bottom 8%, leaving 84% of the items in the CPI. For the Dallas Fed, they use the Personal Consumption Expenditures (PCE) price deflator and lop off the top 31% and bottom 24% price changes. 

The problem is that this approach assumes that price spikes (or declines) are not only transitory, but independent. What happens if those tails you chopped off end becoming important ingredients in other prices that may not be exhibiting really large increases today? In the above chart, I have overlayed the Cleveland Fed’s trimmed mean measure of CPI inflation against headline inflation. If we look back to the pandemic, you will see that even though headline inflation was moving sharply higher one year after the initial economic hit from COVID-19, the trimmed mean measure was sitting closer to 2.5% - not far from the Fed’s target. The Dallas Fed’s trimmed mean PCE measure was even more stark and was below 2% in April 2021, as seen in the above chart. This, plus uncertainty surrounding the direction that demand would take was the primary justification for holding interest rates lower for longer.

As we now know, this was a big mistake and by delaying even a gradual move higher in rates, inflation was allowed to move even higher, ultimately requiring aggressive tightening and an eventual correction in both bonds and equities in 2022. Today, I would argue that we are at risk of repeating history. Not necessarily in terms of how high inflation will go, nor the degree of tightening that might be required by the Fed, but in the potential damage to economic fundamentals and markets. Like what, you might ask?

For one, if consumers spend $100 more on energy, they spend $100 less elsewhere unless there is an offsetting improvement in their income or they tap into credit. As for businesses, excluding energy from inflation data doesn't exclude its impact on corporate earnings. Then there is the transmission effect from potentially higher interest rates. If the market "deludes" itself into thinking rates will fall, and instead bond yields stay "higher for longer" (or move higher), the net present value of future earnings declines. If the price of a stock is a reflection of that discounted stream of earnings, eventually the market will adjust that price lower. Not quite what is happening these days with US indices at all-time highs. As the above chart shows, long-term bond yields in the US are already at elevated levels that (for now) haven’t really spooked the equity market.

With Warsh likely to be confirmed next week by the Senate, the focus will shift to the next Federal Reserve FOMC meeting on June 16-17th. We will get two more CPI reports between now and then and I would expect to see more “bleed” into the headline numbers than the initial reports since the start of the Iran war. It is clear from commentaries made by some Fed officials that there was definitely a push against the language out of the last FOMC meeting that an easing bias be left in versus a shift towards the possible need for higher rates. The question will be whether Fed officials lean on the trimmed mean estimates to refrain for a tightening bias. As much as stocks would love to not see rates move higher, the risk is that a continued lift in prices even in those categories that are excluded, could ultimately send those trimmed inflation numbers higher.

On behalf of the Pyle Wealth Advisory team, have a wonderful week.     

Andrew Pyle