Don't be fooled by the financial headlines in the coming months. They'll most likely read that inflation, including energy, is the lowest it's been in years. Technically, that will be true. But, as usual, the devil's in the details.
Inflation is calculated by looking at the change in the price of a pre-determined basket of goods. That basket of goods is supposed to represent the collective buying patterns of the group being analyzed. So we can define the group as all consumers, all urban consumers, all people over 40, all people living in the South, etc.
Recently, we've seen a sharp increase in the cost of energy, as well as goods or services that use a significant amount of energy. But even with that sharp increase, overall inflation has been modest by historic standards. As fuel prices stop rising — and perhaps even decline — we should see a reversal of the inflation data that's currently affecting interest rates, housing values, auto sales and, some say, trade imbalances.
Through the end of the year, we will likely see lower inflation numbers. But those numbers will be misleading, primarily because there's been a fundamental shift in the contents of the basket of goods used to calculate inflation as people adjust their spending patterns to accommodate changes in the cost of some basic living expenses.
For example, we now pay more for housing, not only due to rising mortgage rates, but also due to higher property valuations and taxes. Homeowners' insurance is another area where costs are escalating, not only to cover losses such as those related to hurricane damage, but also to reflect the higher valuation of the home.
How does the consumer adjust? In part, by changing what they put in the basket. Longer terms for non-revolving debt may cause individual debt payments to decline, but they're now stretched out over a longer period of time. Another example is increasing the deductible on insurance coverage, which may keep premiums from going up — or at least minimize the increase. At the same time, however, this creates a risk for the consumer. The risk is real, but it doesn't show up in cost of living calculations.
The example most often given is the claim for damages on a home, however incurred. Most home-repair costs are rising faster than overall inflation because electricians and plumbers are in short supply and can get a premium for their services. In addition, the price of home-repair materials is also going up. Thus, any damage could result in a significant out-of-pocket expense for the homeowner. But some homeowners can't come up with the money to make the needed repairs. This could result in foreclosure or perhaps a devaluation of the property. In either case, the purchasing power of that household is diminished - something normally attributed to inflation.
What does it all mean? No big deal at the moment, but over time the consumer will adjust. Just as consumers took on the risk of health care funding (or lack thereof) in the past two decades, so will they take on a greater share of the risk of ownership. Generally, we would expect people to save for a rainy day so they can cover these expenses if they have to. However, all evidence points to that not being the case. The alternative is immediate sourcing for external funds, i.e., a loan — either as a stand-alone or as an adjustment on the equity of the asset involved.
Indeed, it appears that consumers are adjusting their basket of goods in terms of quantity and content. But we can also expect them to increase the amount of risk they're willing to take. This, in turn, could lead to more volatile swings in consumption due to the need to cover the risk in time of need.