to continue improving.
One area that can become confusing is the inflation rate. We’ve recently seen the inflation rate far below optimal levels, and this could be a concern.
The reason why we wouldn’t want outright deflation is that this completely turns an economy on its head. You would not be interested in buying a product or investing in equipment for your business if you knew that the price continues to drop every month. This also means your income will eventually decline.
However, when the inflation rate is too high, that is also very destructive, as it erodes the value of money.
There is such a thing as good inflation and bad inflation. If the inflation rate was low, stable, and prevalent throughout an economy, this could be construed as positive inflation. Consumer spending would be stable because people would know that prices wouldn’t continue dropping.
In this scenario, the inflation rate would indicate that the rate of increase would be approximately the same amount for everything and everyone. This means all prices are generally moving up at a low level, such as two percent, including wages, investments, real estate, and the products you are selling at your own business.
However, I would warn that if the inflation rate were to rise from a shock to the system, such as energy prices, this could become negative inflation. If the inflation rate were moving up primarily because energy costs are going up, this would be detrimental to consumer spending.
Because the income level in that scenario would not be rising at the same rate as energy costs, this difference would be felt by individuals who would then reduce their level of consumer spending, especially on discretionary items.
The latest report on the inflation rate from the consumer price index (CPI) by the Bureau of Labor Statistics indicated that for the month of June, the seasonally adjusted headline CPI increased by 0.5% from the previous month. The unadjusted one-year change is an increase of 1.8%. (Source: “Consumer Price Index Summary,” Bureau of Labor Statistics web site, July 16, 2013.)
What was the biggest component for the increase in the inflation rate? Energy costs.
The increase for gasoline was 6.3%, and energy commodities increased 5.7% in June versus May. The vast majority of the overall increase in the inflation rate was this energy sector.
Since we know that incomes are only increasing at a marginal rate, if energy costs remain elevated, I believe that consumer spending could be vulnerable in the second half of 2013.
I will be watching stocks that are involved in discretionary consumer spending this earnings season to see if they give any negative guidance. If they are too optimistic, I would certainly be cautious, because consumer spending cannot continue rising if the inflation rate also rises without a subsequent increase in income.
This article is brought to you courtesy of Sasha Cekerevac from Investment Contrarians.
Related: Consumer Discretionary SPDR ETF (NYSEARCA:XLY).