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By Robert Johnson, CFA and Jeremy Glaser | 10-19-2016 11:00 AM

Johnson: U.S. Faces Stagflation Threat

The Fed is in a quandary as inflation data confirms that price levels could keep rising, but growth remains tepid.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Inflation data this week confirmed that Social Security beneficiaries are going to get a very small increase this year. I'm here with Bob Johnson, our director of economic analysis, to look at that inflation data and what it can mean.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: Let's start by looking at that headline inflation number. Any signs of acceleration here?

Johnson: The headline number overall hasn't got much worse in recent months. We've kind of been at that 1% to 1.1% over the last several months on that headline inflation number. But looking back, it kind of creeps up on you, but a year ago at this time the number was more like 0.10%. So we really have moved up quite a bit even on that headline number but the 1%, 1.1% seems kind of tame. Now you look at the core number and that number is again higher, about 2.2% and again if we look back a year it was more like 1.8%. So its moved up maybe not quite as dramatically, but it is 2.2%. And as the effects of energy kind of burn off as we kind of stabilize--not even increase but stabilize--energy prices, it's highly likely that we'll move to that core number of about 2.2% inflation.

Glaser: So now this report is used to calculate what Social Security is going to look like next year. It's going to be a pretty small increase.

Johnson: It absolutely is, and remember this time around they are going back to 2014 data to compute the number because we didn't have a Social Security adjustment at all last year, recall there was no hike in the social security payments at all in 2016. Now as we look to 2017 the number will go up whopping 0.30%--hardly any better.

Glaser: And you say that's around $5 for the average Social Security.

Johnson: Right. The average check's about $1,300 and that 0.30% gets you about there. So certainly not good news especially considering Medicare premiums for some will go up, not all, but for some, and in addition for everybody the deductibles will go up more than the amount of your increase in Social Security. So certainly not a good situation.

Glaser: And for those that are currently working the wage base is going to increase quite a bit more.

Johnson: Yes, there are some very tricky things there but usually the wage base determines how you set your rate and how much you, what your limit is and what's withheld. And it was about 118,000 and that's going to move up to 127,000, because we are going to have a catch-up here. Because you are not allowed to adjust that base in years when there is no regular Social Security increase. So we are going to get a double whammy of two years of increases, and wage increases have done better than inflation and so therefore this index is going up quite a bit. So people in the higher income brackets going to face a pretty nasty tax increase from this higher wage base next year.

Glaser: So if you have higher taxes on some workers and then lot of retirees maybe not seeing a big change to income, does that make you a little bit nervous about consumer spending? There is just less money out there to spend.

Johnson: I absolutely do. It's a big deal, and I think it partly restraints some of the numbers this year, next year it's going to be even worse with the wage base issue. But it's very small increase that's out there and that's about one in five, one in six people in the U.S. economy get some type of benefit currently, that's tied to that number. And so they are not getting a rate increase and as we just talked about inflation is accelerating, but this is kind of look back number. So the chances are they are going to pay prices that are about 2% higher next year and they are not going to get any increase in their base. So that's really a nasty combination for a decent part of the economy. So clearly that's one of the reasons that we've been more pessimistic lately. We usually are relatively optimistic on the economy. But we've got some pretty grave concerns right now.

Glaser: Let's look at the impacts on the Fed then, If you do see inflation coming up and you see growth being very slow, are we back in stagflation, if I can dust that one off.

Johnson: Yes, I kind of think that’s where we are at. I think we are going to be looking at over 2% inflation and very limited GDP growth kind of in the 1.5% to 2% range. So we are clearly in a situation where we are facing slower growth, but on the other hand because of demographics and just the way things flow through and energy not falling as much as it was. We are going to be in a situation where inflation is moving up at the same time that growth rates are kind of moving down, the very definition of stagflation. And it puts the Fed in a terrible bind in what to do and why everybody is having such a hard time figuring out what they will do, because you've got this clearly brewing inflation issue out there. And at the same time you've got this issue where I think it's going to be very clear to people over the next two or three months, we've had a pretty dramatic slowing in the U.S. economy.

Glaser: So a December rate hike is still a possibility? How do you think they'll handle it?

Johnson: Its still a very real possibility. It depends on how bad the economic data gets between here and there. If it kind of, some of the smaller things that we are seeing don't brew to the surface by December, then they'll look at the inflation data and say you know what, we should probably do something. But if we have a couple of bad employment reports, if we see a really poor GDP report for the third quarter--those are all things that would make them hold back. Personally I think they should have moved earlier while the economy was a little bit stronger, and that would have actually reassured people in a way that they had enough confidence in the economy to raise rates. Now, I think, it's kind of too late. I think if they raised rates now, it would sink the economy. So, my advice to them has probably changed over the last six to nine months.

Glaser: And we did see some poor reports this week particularly in housing.

Johnson: I was not at all pleased with the housing report, and again a lot of people are making it out as a pretty dramatic number. They are looking at the number month-to-month and saying we are down 10% month-to-month. Well the month-to-month numbers are always volatile and we've got those tough seasonal factors and starts were running way ahead of permits for a while. So the starts data look really quite poor and that also is true year-over-year. But if you look at it in a more rational basis and look at kind of rolling 12-month basis, we're still growing 8%, 9% year-over-year in the single family market which is the key market. But again that’s not the 12% that it was say six months ago. So, we've kind of slowed there, and that's not good news because we have lot of visible problems in the economy and we'd hope for housing to kind of bail us out if you will, and certainly the permits data this week did not do that.

Glaser: Well, Bob, as always, I appreciate your analysis.

Johnson: Thank you.

Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for watching.

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