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Airline Loyalty Miles Have Become Money, not Tokens
I noticed something recently about the many, many airline loyalty miles that my family has accumulated over the years.
Loyalty miles began as a way for airlines to induce brand loyalty in a market that was very fractured post-deregulation (the U.S. airline industry was deregulated in 1978; the American Airlines and United Airlines loyalty programs were created in 1981…although Texas International Airlines is credited with creating the first loyalty program in 1979). In the Old Days, miles worked something like the punch card at the ice cream store, but instead of getting a free scoop of ice cream after ten purchases, it was a free trip after so many segments flown. Because airlines get compensated basically by the number of passenger-miles they create, the loyalty programs were tied to how many miles you flew. Fly more miles, get more miles. But the redemption was fixed: originally, 20,000 miles got you one round-trip domestic coach ticket anywhere the airline flew.
When you get your free scoop of ice cream, it isn’t the scooper’s decision what flavor you get. It’s yours. With ice cream, that’s no big deal; one flavor costs the ice cream parlor about the same amount to deliver to you as another. But with airlines, the problem is somewhat bigger.
Quantitative aside: experienced rates traders may see an echo of the bond-contract structure where it is the seller of the contract who gets to decide which bond to deliver. This optionality is worth something to the seller, and costs something to the buyer, so the bond contract trades at a lower price than it would if there were no delivery options. In this case, it is the buyer who gets to choose what product the seller must deliver (with limitations, of course). So it is very clear that loyalty programs, at least in the traditional structure where the price of the benefit was fixed at 20k or 25k miles, were very valuable to the customer. So did the customer pay more for a fare than he/she otherwise would, to get miles? We may never know.
When the award was “any flight [other than some blackout dates]” and the cost was “20,000 miles”, the strategy was fairly clear. You wanted to wait until you had to buy a high-priced ticket, and buy that ticket with miles instead. In fact, spending the miles on a $400 ticket had a potential opportunity cost because then you wouldn’t be able to spend them on a subsequent ticket that cost $500. So the strategy was to wait, because the option had value. Moreover, inflation worked in your favor as tickets over time rose. There was no realize cost of carry to penalize not spending the miles…so the strategy was to wait. Your loyalty miles were an inflation-linked bond, whose value was linked to airline fares. Actually, an option on an inflation-linked bond…but I digress.
This has changed.
A few years ago, airlines started varying the amount of miles needed to book certain tickets. Tickets on high-load-factor flights started to cost more. In a way, this was not terrible because it meant that some tickets were available at a higher cost, that previously would have been blacked out. So your 25,000-mile award wouldn’t buy the ticket, but you could get it for 50,000. This was successful, and over time what happened is that ever-finer gradations of mile-award-amounts-needed began to show up.
I took an hour this morning and went on United’s website. I priced economy, non-stop, round-trip tickets for EWR-LAX, EWR-ORD, EWR-DFW, EWR-IAD, EWR-BOS, and MIA-SEA(one stop as there were no directs), for March 24-March 26. I collected the price for each departure time. Then I collected the mileage required to buy the ticket in lieu of cash. The chart of this little experiment is below. The x-axis is the miles needed; the y-axis is the dollar cost, and each dot represents one fare pair.
You may notice that the blue dots are arranged in a surprisingly linear way, at least until 32,500 where it seems there is a cap of sorts. In fact, a linear regression line run through the points produces an r-squared of 0.88, and you can get it to 0.95 or so if you use an exponential curve. But the linear line is instructive because the slope of the line indicates that one airline mile on United is worth almost exactly 2.5 cents. As an aside, I didn’t check other loyalty programs but I would be surprised if the slope of American’s line or Delta’s line was meaningfully different.
The red line is where the old 25,000 award would be. If that was still the cost of a ticket, a buyer would not waste it on the tickets to the left of the line and would only use it on those to the right of the line.[1]
So, let’s call a spade a spade: one airline mile on United is 2.5 cents. When airfares go up, your pile of miles becomes less valuable in real terms. Loyalty miles are now indistinguishable from money, in the air travel marketplace.
Here’s the interesting part. Because loyalty miles are now money, the strategy that you the customer should take completely changes. Before, your best strategy was to wait, allow miles to accumulate, and only use them when prices spiked. Now, because miles are money, your best strategy is to spend them as quickly as you can. They don’t earn interest, so they are a wasting asset in real space. It doesn’t matter if you buy one $800 ticket for 32,000 miles, or two $400 tickets for 16,000 miles each. The value is exactly the same.[2] Ergo, they’re money. Not only that, they’re money that can only be spent on airline tickets, and they have a credit component because if the company goes out of business *poof* there go your miles.
Actually, they can be spent on other things, but the optimal way to spend them is probably on airline tickets. I looked at how many miles I would have to exchange to rent various car sizes from Avis in Newark, for two days starting March 24. I added these dots to the chart below.
So the final moral to this story is: don’t rent cars with airline miles!
[1] Class exam question: draw the consumer surplus that the airline reclaimed by changing the pricing structure.
[2] A small caveat to this would be if the current apparent cap at 32,500 for a coach economy class ticket is fixed, because over time more and more tickets would be pricey enough to be capped. However, I think it is unlikely airlines will hold a cap in that way.
Summary of My Post-CPI Tweets
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. And sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com.
- core CPI+0.13%, softer than expected. Core y/y rose from 1.77% to 1.80% due to soft year-ago comparison.
- Next month we drop off an 0.05%, so we will almost surely get a core uptick. Surprising we haven’t yet. Waiting for breakdn.
- Both primary rents and owners’ equiv accelerated slightly, Which means core EX HOUSING was actually slightly down m/m
- core services rose to 2.6% (mostly on housing); core goods fell to -0.5% from -0.4% y/y. Same story overall.
- Apparel accelerated to -1.64% from -1.85% y/y. Story for years in apparel was deflation; in 2011-12 prices rose>>
- >>and looked like return to pre-90s rate of rise. Then it flattened off, and has been declining again.
- Apparel could well be a dollar story now – it’s almost all made overseas, almost no domestic competition so dollar matters.
- our proxy for core commodities is apparel + cars + med care commodities. all 3 decelerated. Cars went from +0.5% to 0.0% y/y.
- sorry, Apparel actually ACCELERATED to -1.6% from -1.9%, but still negative.
- airfares not really a story. -5.6% y/y vs -5.2% y/y. The NSA number dropped but it always drops in late summer. [Ed note: see chart below]
- airfares was -8.5%, but it was -8.1% last july, -2.9% in 2013, -2.6% in 2012…no story there. didn’t affect core meaningfully.
- Primary rents 3.56% from 3.53%. OEW 3.00% from 2.95%. Both will continue to rise.
- Lodging away from home also rebounded to 2.9% y/y after a one-off plunge to 0.8% y/y last month. Household energy of course down.
- Transportation accelerated (-6.6% y/y vs -6.9%) on small motor fuel recovery. btw, airline fares are only 0.7% of CPI, so 0.9% of core.
- Med Care: goods were dn (drugs 3.2% vs 3.4%,equipment -0.9% vs 0.0%) but prof services up (2.1% vs 1.8%),hospital svcs dn (3.2% vs 3.5%)
- Health insurance only +0.9% y/y vs 0.7%, but more expenditures out-of-pocket under the ACA so higher infl for those categories hurts.
- Median (due out later) might only be +0.1% this month. I have it cuffed at 0.15% but I don’t seasonally-adjust the housing sub-components.
- Last yr Median was +0.17% m/m, so best guess is it roughly holds steady at 2.3%.
- I don’t see how the Fed embarks on a meaningful tightening in Sep, with global economy weaker than it has been in a couple yrs.
- Median inflation and growth plenty strong enough to “normalize” rates but that’s not a new story.
- I’ve been saying they should tighten for a few years but not sure why they would NOW if they didn’t in 2011.
- But Fed doesn’t use common sense or monetarist models.It’s all DSGE;who knows what those models are saying?Depends how they calibrated.
- FWIW our OER models diverge here. Our nominal model says pressures on core start to ebb in a few mo; our real model predicts more rise.
- I like the real model as it makes mose sense…but it’s not tested in a real upswing.
- US #Inflation mkt pricing: 2015 0.8%;2016 0.7%;then 1.6%, 1.7%, 1.8%, 1.9%, 2.0%, 2.1%, 2.2%, 2.3%, & 2025:2.2%.
- …so inflation market doesn’t see inflation at the Fed’s target (about 2.2% on CPI vs 2.0% on PCE) until 2023.
- The market is not CORRECT about that, but another reason the Fed can defer tightening if they want to. And they have always wanted to.
First, let’s start with the airfares chart. One of the early headlines was that airfares plunged by the most since some long-ago year, which held down core. Well, here is the chart of airfares, non-seasonally adjusted. You tell me whether this is unusual to have airfares fall in July.
Because this is part of a normal seasonal pattern, the year-on-year figure was only slightly lower, as I note above. And airfares are a tiny part of CPI, less than 1% of the core. This is not a story.
More important will be the median CPI. This is a much better measure of the central tendency of prices than headline or core, both of which (as averages) can be skewed by a few categories having outsized moves. Median inflation has been ticking higher (see chart below) but will probably go sideways this month.
Finally, the most important chart. There are lots of ways to model housing. If you model rents as lagged versions of the FHFA Home Price Index, or Existing Home Sales median prices, then you get one model and that model suggests that rents should begin to moderate over the next 6-12 months. Not that they will decelerate markedly, but that they will stop accelerating and therefore stop being the driving force pushing core CPI higher. But if you use those models, you have to recognize that you are calibrating over a period of very slow inflation, so that you are effectively ignoring the knock-on effect of higher inflation on rents. That is, if core inflation is around 2% and rents are 3%, then if core inflation rises to 5% you wouldn’t expect rents to be at 3%. So, you need to use a model that recognizes the interrelationship between these variables. And that sort of model implies that rents will continue to climb. Both models of Owners’ Equivalent Rent are shown in the chart below. I prefer the “real” model to the “nom” model, but we don’t know the right answer yet.
Even if OER moderates it doesn’t mean that CPI will stop rising; it just means that the story will stop being all about rents. Core goods still have a long ways to go to normalize, and that might be the next story. But for now, I am still focused on rents.
As I said, I really don’t see how the Fed can think about hiking rates in September based on the data we have seen recently. Yes, inflation is on the border of being an issue, but that has been true for a long time. In 2011, there was plenty of growth and while high rates would not have been warranted, it is hard to argue that normal rates were not called for. And yet, we got QE and more QE. This will end up being the biggest central bank error in decades, regardless of what the Fed does in September. I doubt they will hike, and if they do then it won’t be a long series of hikes. This is still a very dovish central bank, and they will get skittish very quickly if markets balk at more expensive money – which, of course, they are wont to do.
