How Shadow Inflation Will Haunt Investors (March 5, 2024)

For signs of mismeasured inflation, look to services, labor and crypto

By Lisa Beilfuss

An in-line inflation report last week prompted a collective sigh of relief across Wall Street. That may be short sighted. 

In January, personal consumption expenditures rose 0.3% from a month earlier and 2.4% from a year earlier. The PCE excluding food and energy, the Federal Reserve’s favored inflation metric, increased 0.4% month-over-month and 2.8% year-over-year. Hot consumer price and producer price indexes for January, plus signs of renewed inflation in recent manufacturing, services and small-business data, had investors on edge about an upside PCE surprise.  

A PCE overshoot, at least with respect to the headline figures, didn’t materialize. But investors’ skepticism might be more appropriate than relief. Looking under the surface, investors should consider what the PCE is missing and think about second-order effects of understated inflation.  

Post-pandemic, misgivings over economic data have become mainstream. But there is a difference between, say, the impact of dwindling response rates on the nonfarm payrolls report and inflation mismeasurement.

In particular, shelter and healthcare costs are mismeasured, says Vincent Deluard, director of global macro at the StoneX. He lays it out this way. To those who have declared inflation dead, inflation is the CPI (or PCE) and what gets measured is what matters. But what doesn’t get measured–such as the homes young people can no longer afford and soaring health insurance premiums–also matter.

Deluard illustrates this idea in terms of the CPI. But the logic and data are relevant for broad inflation analysis. ​​The Daily Treasury Statement shows that healthcare expenses are growing much faster than the medical care services price index, which is showing 0% inflation and still below its June 2022 peak. That is as spending by the Veteran Affairs department and Medicare Part A soared by 15% and 18%, respectively, last year. 

The cost of health insurance, meanwhile, is measured by insurers’ retained earnings, or premiums minus benefits spending. Retained earnings are down 23% year-over-year. Contrast that with data from the Kaiser Family Foundation, which show average annual premiums for employer-sponsored family health insurance coverage rose 7% in 2023 from 2022, and are on track to rise even faster in 2024. 

Deluard suggests the retained-earnings method is silly, but he says fixing the data wouldn’t matter; healthcare is one of consumers’ biggest expenses, but healthcare and health insurance are just 6% and 0.6% of the CPI, respectively. That isn’t to mention that the PCE, where healthcare has a heavier weighting, is indexed to the rate of inflation in Medicaid rates–which are negotiated by the government and have been inflating at a much lower rate than private care.

Mismeasurement amounts to shadow inflation that inevitably finds its way into the labor market, materializing as sticky wage growth, persistent service inflation and uncontained deficits, Deluard says. 

“Someone is paying for actual health expenses, which account for 17% of GDP growth at 7% per annum. Someone is paying (more) to convince workers to abandon mortgages locked in at 3% and pay inflated rents to move for a new job,” he says. Consider the premium for job switchers has jumped to 6% from 4% before Covid, and the costs of wage-intensive services have reset to a plateau of 5-6% for three years. 

It is unlikely, then, that the renewed rise in so-called supercore inflation is a blip. Fed Chairman Jerome Powell since late 2022 has placed particular emphasis on a cut of price indexes that exclude food, energy and housing. Because supercore captures the labor-intensive services sector, it is especially sensitive to nominal wage increases. 

Supercore PCE, representing about half of the total index, rose 0.6% month-over-month in January, the biggest increase since December 2021. From a year earlier, the gauge ticked up to a 3.5% pace. On a 3-month annualized basis, it rose 4.1%--more than double the Fed’s target. 

Economists at the Boston Fed found last summer that the prices of services associated with low-skill workers have driven supercore inflation. They wrote that services have a particularly low frequency of price change, with prices remaining the same for about 15 months on average. Now consider recent survey data from the National Federation of Independent Business, which show a rising share of firms plan to raise prices in coming months. 

It is worth going a step further, beyond the impact of mismeasured inflation on labor. The global crypto market cap stands at roughly $2.52 trillion, according to price-tracking website CoinMarketCap. While that is off a November 2021 high of $2.92 trillion, it is up about 150% from September. That is as daily trading volume across cryptocurrencies has recently picked up to match late-2020 levels. For context, the overall crypto market cap was about $200 billion before the government increased the money supply by 43% in response to the Covid pandemic. M2 money supply is still 36% above December 2019 levels. 

As Bitcoin recently touched all-time highs, 18 new crypto coins with a combined market cap of $26 billion have become tradeable in the past 12 hours (as of writing) alone. What is going on in the crypto market helps make the case that financial conditions aren’t restrictive. But there is a bigger message. The crypto market isn’t just reflecting excess money, but effectively printing more. Crypto is part of the shadow-inflation story, which itself is the (nominal) U.S. growth story.

As one crypto trader put it, about $1.5 trillion in new crypto wealth has been created in the last 15 months. That is equivalent to roughly a quarter of the $6 trillion in Covid-related fiscal spending.

“You literally can’t afford a house unless you YOLO,” another trader said, adding that a renewed crypto boom can be much bigger than the last because of how embedded inflation expectations have become. “You can make 200k a year and not afford a home. People feel the need to take risk, and they are.”

The Fed’s favored inflation gauge, not to mention the CPI, will fall back to target before it should. Aside from reducing longer-term economic efficiency, Deluard warns that “the ghost of shadow inflation” feeds populism, social instability, and geopolitical tension. As such, he suggests investors hedge with long-term TIPS and inflation swaps, plus “chaos assets,” or USD cash. gold, and energy.

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Note that Praxis is off next week and look forward to publishing the week of March 17.