ACTV - Reality Slams The Casket Shut On Inflation

2023-04-12 17:36:27 ET

Summary

• Each month adds another nail to the coffin.
• Year-over-year metrics are still living on the glory days of early 2022.
• Inflation bears need a better thesis - the argument is already decomposing.

The argument about inflation was further crushed today:

Looking at the values in total relative to January 2021, we get the following chart:

For comparison, if we used ZORI (Zillow Observed Rent Index), the total rent growth since June 2022 went from $1,955.96 to $1995.54. That's 2%, or 2.7% annualized. That's dramatically lower than the 8.5% annualized rate in the "shelter" data. For comparison, ZORI correctly recorded dramatically higher shelter inflation much earlier.

Higher interest rates weaken inflation by reducing demand. That's how they're supposed to work. However, higher interest rates won't help with shelter inflation. Shelter inflation reflects the increase in housing rent (with a significant lag period). The lagged shelter inflation should gradually decrease over the rest of the year, but it's currently the only factor supporting headlines about high inflation.

What Would Actually Stop Shelter Inflation?

How do we actually make housing more affordable? There are precisely three methods, only two of which are acceptable.

1. Increase supply to meet demand by stimulating construction (mainly through lower interest rates relative to inflation).
2. Increase supply to meet demand by dramatically reducing costs (mainly by eliminating fees and delays from the process)
3. Reduce demand through mass death (not acceptable). We're going to toss this one out.

Since reducing demand is not viable, increasing supply is the solution to rising rents. If you've been alive for a while, you're probably aware that home prices grew dramatically faster than wages.

Low Rates

While lower interest rates enabled consumers to pay higher prices, that's a smaller part of the equation. We can see how the market reacted to a combination of lower interest rates and high expectations for inflation:

Clearly, lower interest rates combined with inflation drove a huge investment in assets that can grow rents with inflation. Whether we like that as a "solution" or not, the connection is clear.

Reducing Costs

Profit margins on construction are not absurdly high. In fact, you can already see that the projected volume of new starts is set to plunge. If profit margins were still soaring, new starts would not be projected to decline to levels last seen around 2013.

The problem is that 40.6% of multifamily development cost comes from regulation. If the apartment costs $300,000 to build (per unit), on average, the cost would break down to about $121,800 in regulation. In theory, that only leaves only $178,200 for actually building the place where someone will live. However, it is actually even worse.

Those costs don't include opposition to development from local non-government groups. On average, those costs add another 5.6% to the total development cost. Consequently, the total left for building the unit is materially less than $178,200.

Some of those costs are reasonable. Building codes are sometimes flawed, but they can also prevent bad outcomes.

Grocery Inflation

Remember all the headlines about eggs? Remember people arguing for double-digit interest rates because they were angry about eggs? I remember it. We even wrote an article covering the cost of eggs, coffee, and vegetable oil .

We explained very rationally that capitalism still works. Farmers would respond to higher egg prices by raising more hens. Further, we made the amazing deduction that more hens would lead to more eggs and more eggs would lead to lower prices.

As it stands, the cost of eggs is starting to decline:

Of course, that data is quite flawed since they simply lumped organic, non-organic, cage-free, free-range, and "traditional" into one category. How much do a dozen cage-free eggs cost at Walmart? I'll check their website. Why would anyone ever spend their life walking around a store? Here's the listing:

That's way cheaper than $4.21. The last time FRED reported a price below $2.67 was in April 2022.

Fed Funds Rate

The target short-term interest rate may rise again in May. Currently, it's hard to say either way.

However, we should see at least a moderate shift in the rhetoric as the Federal Reserve will want to evaluate its success so far. The market continues to expect a significant shift later this year, as the narrative around inflation will be dramatically different.

The expected year-end rate is forecast in the 400 to 475 range. Only one month ago, the odds were calling for 450 to 550. Even as the Federal Reserve hikes rates, the two-year Treasury yield flattened out to around 4%.

The narrative about inflation already is dead; it's just dressed up, propped up, and carried around by guys who want to hide the truth. Basically, inflation is like Weekend at Bernie's . A few people vocally pretend it's still alive to keep the party going.

Conclusion

Inflation from 2021 through the summer 2022 was huge. Since then, inflation has been quite mild. The bears focusing on the year-over-year numbers will need to pivot to a new talking point in July 2023, because those year-over-year numbers will be pretty weak. After July 2023, we should see the rate of inflation (in CPI) coming down gradually as the lagged shelter data wears off. That doesn't require any change in current market prices. It's simply the impact of using lagged data to create headline numbers.

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