According to the Ex-Energy version of the Consumer Price Index, inflation has been averaging about 2% per year for well over a decade. Of course, when you add back in energy prices—which have experienced gigantic swings from a low of $10/bbl in 1999 to a high of $150/bbl in 2008, to the current $50/bbl—inflation has been quite volatile. But if ever there were a time to ignore the impact of energy prices on inflation, now is the time. In real terms, oil prices today are only about 10% less than what they have averaged since 1970. So focusing on ex-energy inflation is justified and appropriate, since energy prices have increased by almost the same as all other prices, on average, for the past 45 years. Energy is not noticeably cheap nor expensive relative to other prices these days.
The chart above plots the Ex-Energy version of the CPI on a semi-log scale. It shows that inflation has had a strong tendency to average 2% per year. The only thing unusual about the behavior of inflation was in the 2006-2008 period, when core inflation reached almost 3% and ex-energy inflation slightly exceeded 3%. Since then, and despite massive increases in bank reserves, inflation has been remarkably stable and relatively low.
The chart above draws our attention to the current episode of a major decline in oil prices, and the decline of similar magnitude which occurred in 1986. Both times oil prices plunged, only to later rebound. In 1986 the headline inflation rate collapsed, then returned to the prevailing level of core and ex-energy inflation about a year after oil prices started to rebound. This time should be no different. Today we learned that the CPI increased by 0.4% in April, lifting the year over year rate to 1.1%. If the monthly increases in the CPI are only 0.2% per month for the rest of this year, inflation for 2016 would be 2.0%. That's not difficult to imagine at all.
The Fed is well aware of this dynamic, which is why they haven't panicked over the low rates of headline inflation we have seen over the past year or so. What worries them is that the economy remains sluggish and they know that the market is very nervous about the potential for higher rates to weaken the economy further. I don't think another 25 bps hike in short-term rates would do much harm to the economy, but it's hard to make a compelling argument for doing so. After all, inflation is running right around the Fed's target, and the economy is unlikely to soon defy the myriad headwinds which have been holding it back for the past seven years.
The real action these days is in the election dynamics. The future course of fiscal policy could make a world of difference to the economic outlook in coming years. But for the moment the outcome of the November elections is a jump ball. We'll just have to wait and see how things progress in the months to come. I suspect the Fed will reach the same conclusion and stand pat at the June FOMC meeting four weeks from now.