Tuesday, November 17, 2015

CPI inflation ex-oil still a solid 2%

The year over year change in the CPI has been roughly zero for the past 10 months, but that's purely a function of sharply lower oil prices. Ex-energy, consumer price inflation has been running about 2% per year on average for the past 13 years. What's notable is not the low level of headline inflation, it's the continued existence of 2% core inflation despite the fact that economic growth has been unusually sluggish for a number of years. 

The chart above compares headline CPI inflation with "core" (ex-food and energy) inflation, with the former being much more volatile than the latter.

As the chart above attests, the difference between headline and core inflation is almost entirely due to energy prices. When you strip out energy, you find that inflation has been rising at a 2% annualized pace since the end of 2002, with the exception of the 2005-2008 period, when inflation briefly accelerated. That acceleration followed several years of aggressive Fed easing (2001-2004), and it prompted a subsequent tightening, in which raised the Fed raised its target rate from 1% to 5.25%.

Don't let the low level of headline inflation lull you into thinking that the Fed runs a great risk of triggering deflation or harming the economy if it raises short-term rates to 0.25%. I continue to believe there is a greater risk of inflation accelerating, as it did 10 years ago, if the Fed does NOT raise rates.


steve said...

well that said, IF energy prices don't increase meaningfully then the cpi looks like it needs to be pulled lower-at least that's what your chart would prognosticate.

Scott Grannis said...

How I see it: In the past year, falling energy prices have significantly depressed the headline CPI, while all other prices have been rising at about a 2% annual rate on average for the past 13 years. If energy prices stop declining and just hold steady, then energy will only subtract marginally from the total CPI, which would then approach the level of ex-energy inflation. If energy prices were to stop falling and start rising at 2% per year, then the headline CPI would soon equal the ex-energy CPI.

Benjamin Cole said...

Scott: As you probably know, the Federal Reserve Board targets the PCE deflator, which is now running at 1.3% core YOY. The TIPS market suggests even lower inflation ahead for years and years. Institutional buyers seem happy with 2% yields on 10-year Treasuries. Inflation outlook?

However, I think the fundamental error made in this regard is the lack of appreciation for artificial scarce housing in the United States, caused by ubiquitous socialist property zoning.

Housing costs make up about 40% of the PCE. Ergo, artificially tight housing is a major contributor to the still rather minute rate of inflation we see today. Energy prices are a sideshow.

A new automobile today has the same sticker price as in 1986! Copper is selling for 1995 prices. Aluminum is selling for 1987 prices. For that matter, oil was $45 a barrel in the 1970s and still is. Computers? The Fed caused this?

We have inflation in markets impervious to market forces---housing, college tuition, military outlays, medical expenses.

To get inflation, as measured, below 2% to 3% is to suffocate the economy. That is where we are now.

Sadly, trillions of dollars in real output, income and wealth is being lost because of an obsession with an arbitrary inflation index.

Like I always say, I prefer Full Tilt Boogie Boom Times in Fat City to 0% inflation suffocation.

Scott Grannis said...

Benjamin: Thanks for your comments. I note however that the PCE Core (the Fed's preferred measure of inflation for more than a decade) has risen at a 1.7% annualized pace since the beginning of 2003. So for the past 13 years it has registered about 0.3% less per annum than the CPI Core, which has increased by 2.0% per annum. The TIPS market is priced to the expectation that the CPI will increase on average about 1.3% per year for years 1-5, 1.9% per year for years 6-10, and 1.6% per year for years 1-10. Thus, forward looking inflation expectations (years 6-10) are almost identical to the current Core CPI, and are consistent with a 1.7% annual increase in the PCE Core. That's mighty close to the Fed's professed target—a 0.3% annualized difference is basically a rounding error when it comes to macroeconomic variables. For all practical purposes, inflation conditions are about as close to the Fed's expectations as one could hope for.

William said...

Velocity of M2 Money Stock for Q3 of 2015 = 1.488

It continues to fall along the same downward trajectory. For the record, the peak Velocity occurred during Q3 of 1997 at 2.210 . The most recent peak prior to the Financial Crisis was in Q2 of 2006 at 2.034 .

Judging from the graph at the link below, from 1959 until Q3 of 1987 the Velocity oscillated around 1.75 . That's a guesstimate. Strange how the M2 Money Stock was quarterly reported and widely commented upon during the inflationary era of the late 1970s and early 1980s. I have not read an explanation for its nearly 10 year slide.

Scott, would you care to comment upon the falling M2 Velocity?


Scott Grannis said...

Re: M2 velocity. I've had a number of posts on this subject over the years (http://scottgrannis.blogspot.com/search?q=M2+money+demand). But instead of referring to M2 velocity I have preferred to look at the inverse, which is money demand (M2/nominal GDP). Rising money demand has been one of the key characteristics of the current business cycle expansion. It's virtually unprecedented. The increase in money demand was huge, and that is what forced the Fed to adopt QE: if they hadn't accommodated the increase in money demand we would have suffered from a severed deflation and/or recession.

I have been expecting money demand to slow down, and it has in recent years. But I'm surprised that it continues to increase. I think that means that the market is still predominately risk averse. But risk aversion is slowly ebbing, so we should see the rise in money demand slow and eventually reverse.

Benjamin Cole said...

Cash in circulation is booming as well.

Scott Grannis said...

Currency is up about 7.5% in the past year. That's relatively fast, but not as fast as the 9-11% annual growth rates we saw in 2009, which was a period of extremely strong demand for money.