Warning Signs in February's Inflation Report

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Our director of economic analysis Bob Johnson thinks that last month's inflation data was some of the scariest he's seen in some time. He's here to talk about that and some other recently released economic data.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: Let's start with this inflation report. The headline number didn't look so bad. But you said when you look under the hood, there is a lot to be afraid of.

Johnson: Absolutely. I think on a month-to-month basis, people are saying, no big deal. It shows maybe we're a little weak even. It showed a decline of 0.2%, but that was entirely driven by energy, and most of that was driven by gasoline.

You strip that out, and the inflation numbers looked much worse. On a year-over-year basis, all in, we were up 1% year-over-year, which is still a little bit higher than where we've generally been over the last six months. But if you look at the core inflation--that is, taking out food and energy--we grew over 2%. So, clearly, core inflation has heated up.

And if you look at services, that's why I start to get scared. It's even worse. Inflation there was up 3.1% year-over-year. Part of that was healthcare and a number of other issues we can talk about. But services inflation continues to accelerate.

Glaser: What is driving that services number?

Johnson: A lot of it is healthcare related. We mentioned last month that both drugs and hospital stays were up a lot. We were hoping that maybe that was due to beginning-of-the-year price increases or adjustments that they are allowed to make, and that they got made in the middle of the month or something. But for some reason, the numbers were just as bad in February, with a 0.5% increase in each, which is not a good number. We have been counting on relatively tame medical cost inflation, and now those numbers look pretty scary.

One other thing that's affecting the medical costs on a year-over-year basis is health insurance prices, which are up over 6%. That's clearly a number that's got everybody a little scared and feeling a little uncomfortable.

Glaser: On the goods side, there was an increase, something we haven't seen in a while. Why are those numbers moving up, too?

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Johnson: On the goods side, we're seeing a couple of things. Apparel was up a stunning 1.9%. We had a few months prior of unnatural decreases because of the warm weather, and now we are getting the flipside of that. All the sales to get that inventory off the floor have ended, and now prices have come back up. A lot of the apparel increase was due to women's clothing more than men's, and on the women's side, a good deal of the change was based on coats. We know what's been happening with coats, with up and down temperatures and so forth, and the need to clear out sale items. We also saw autos were up a little bit more than they have been. They have been flat and maybe even down in some months, and that number was up.

We had four or five months in a row where goods were actually down. And now, it's not a big number, but we were up 0.1%. The bad news is that if you've got energy in one column and maybe that gets worse in March, and you've got goods, which had been negative but are now flat-lining, and you've got this continued acceleration in services, it doesn't paint a very good picture. It seems to say that inflation is due to go up again.

Glaser: If you look at the potential for inflation getting worse, do you think the Fed has dropped the ball, and now they are going to be caught flat-footed given that the inflation numbers are going to look much worse than they expect?

Johnson: I think they will, and I think they probably haven't had the time to pull apart all of the numbers to see what's going on. They implied the one thing that they might see that I'm not looking at is that maybe healthcare doesn't stay as bad as it's been, and maybe this clothing and coat thing kind of passes through the numbers. But I do think that it's heating up. And certainly, when they prepared everything [for their latest meeting], I'm guessing they probably didn't have Wednesday morning's CPI data right in hand to look at how much services inflation was really up, which has got to be quite a concern of theirs. I think they will have to act sooner than later.

The bad news is, gasoline prices were up a lot in March--what we've seen so far at least. That implies it's not going to be helpful to the CPI calculation, that it's going to be actually a small increase to the CPI in March.

You add up the ever-increasing services problem and relatively flat goods prices, and now even a little energy inflation creeping in, that's not great news for next month's number, which comes just before some of their meetings.

Glaser: Turning now to industrial production: The headline number was down, but you think that might miss the big story.

Johnson: I do. We've said for a long time that manufacturing--until everybody got adjusted to the lower energy prices and where the dollar was--at the very beginning of 2015, say, since April or May, industrial production had kind of been flat on the manufacturing side, and has hardly changed at all, with maybe some small increases.

When you look at just the manufacturing side of industrial production, we are up 1.8% year-over-year, and keep in mind, for all of last year, we were only up about 1%, and the long-term average is 2.4%. So, we are not obviously having a recession in the manufacturing sector. You hear all these stories about the strong dollar ruining manufacturing. No. Manufacturing is actually holding its own, and I think that's a very important message.

Granted, the headline number was negative because of the weather. February went back to a warmer-than-normal winter weather, and that depressed utility usage, which declined 4.4% in the month. Clearly, that hurt the headline calculation, as did mining, which was down about 1.4% after it had a little break in January, where it did not decline. I'm guessing this was a little catch-up from January numbers that probably should have shown a decline, because it didn't make sense for mining to stop declining.

It was very interesting to look at the headline number being so negative. Everybody said, manufacturing is back in the dumper again because of the high dollar; nothing could be further from the truth. The dollar, if anything, at least until very, very recently, had been a little bit weaker--at least it stopped going up. And the raw manufacturing data had been looking better. So, I think the people who are characterizing today's minus 0.2% headline numbers as back in the dumper again just aren't reading their notes very carefully.

Glaser: Then on retail sales, you said that report was disappointing.

Johnson: That one was disappointing to me. We had a small decline. We had some revisions. The overall numbers just weren't what they probably should have been. Although you look at the pattern over the last three months: In December, when you strip out autos and the gasoline, we were up 0.5%, and then we were minus 0.1%, and now this month we are plus 0.3% on this specialized basis. There is no clear pattern, and it's relatively healthy.

My only concern is that we've been for months harping on this deflation theme, saying you can't evaluate retail sales until you have the CPI report. Unfortunately, now with goods inflation in some categories heating up, I'm a little afraid that these numbers, which aren't adjusted for inflation, aren't quite as good as they look for the month of February. I've got the sneaking suspicion that if you adjust these numbers for inflation, there really wasn't much growth in retail sales.

Glaser: Some numbers that did look pretty strong were in housing, with starts and permits. What did we see there?

Johnson: We had some great numbers, especially on the starts side. We were very pleased with the growth there, and it continues to point to 9%-10% growth from the housing sector in 2016. So, more good news there.

Permits and starts were at about the same level after months where permits had been way ahead. This month, starts played catch-up; we had a really nice month in starts. We love to see strong starts because that actually means jobs and people. Permits are wonderful because they mean good stuff in the future, but now we've actually got the employment and the use of goods that will come out of starts. One of the few bright spots in the retail sales report was actually building materials. People are not only building new homes but remodeling their old ones.

Glaser: Bob, as always, thanks for your analysis.

Johnson: Thank you.

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