Wednesday, June 15, 2011

Inflation is heating up, and it's the Fed's fault

Consumer price inflation topped estimates by a bit in May, but that's only part of the bigger story. As the chart above shows, over the past six months the CPI has increased at a 5.1% annualized rate, having accelerated sharply from a zero rate in the first half of last year. That is indeed a significant pick-up. Notice also that inflation has been unusually volatile over the past 10 years (standard deviation = 2.2%), especially as compared to the prior 10 years (standard deviation = 0.7%). Three times more volatile, in fact.  This is not a coincidence, since Fed policy in the 1990s was proactive and consistently tight, whereas Fed policy since 2001 has been generally reactive and mostly easy. This is like the difference between driving by looking through the windshield compared to driving by looking in the rearview mirror.

The pickup in inflation is not limited to the headline number either. As this next chart shows, the core CPI has increased 1.5% over the past year, and as the next chart shows, over the past six months the core CPI has increased at a 2.1% annualized rate; like its headline counterpart (compare to first chart), the core CPI has accelerated meaningfully from an almost-zero rate in the first half of last year. It also has experienced significantly higher volatility in the recent decade than in the prior one. So the volatility of inflation is not just coming from food and energy prices, it's most likely coming from erratic and accommodative monetary policy. Finally, as the above chart suggests, with inflation heating up we have likely seen the lows in 10-yr Treasury yields.

To further prove my point that monetary policy is the force behind inflation, note in the chart below how the dollar was generally stronger in the 1991-2001 period, while it was generally weaker from 2002 on. Tight monetary policy keeps the dollar strong and inflation stable, while accommodative monetary policy leads to a weak dollar and more volatile and higher inflation. 

UPDATE: The chart below shows inflation according to the Cleveland Fed's Median CPI.

To calculate the median CPI, the Federal Reserve Bank of Cleveland looks at the prices of the goods and services published by the BLS. But instead of calculating a weighted average of all of the prices, as the BLS does, the Cleveland Fed looks at the median price change—or the price change that’s right in the middle of the long list of all of the price changes. According to research from the Cleveland Fed, the median CPI provides a better signal of the inflation trend than either the all-items CPI or the CPI excluding food and energy.

I have long questioned whether the median CPI is the best way to judge the underlying inflation trends. I've argued that inflation was rising long before the median CPI turned up, and I based my forward-looking view of inflation on the behavior of the dollar, gold, commodity prices, and the slope of the yield curve. In any event, it's nice to see that the median CPI now agrees with the other forward-looking indicators that I follow: inflation is heating up. It's not dangerously high by any means, but there is a clear upward trend which is likely to continue.


Benjamin Cole said...

Great charts....but.

Basically, the real decrease in the exchange rate of the dollar was from 2002-2008 (chart #6). It has bumped along the bottom since.

Yet the CPI core has stayed well below 3 percent most of the time, and is now at 2 percent.

Two percent? This is something I am supposed to be worried about?

The big challenges are boosting output, employment, and cutting the federal deficit.

The Fed? I can't say I feel smarter than Bernanke. I think he is a deeply learned, earnest fellow, very circumspect, cautious, cerebral.

In contrast, I feel a lot smarter than Bush or Obama, or at least smarter than the policies they have enacted.

Bill said...


Do you see a '70s style stagflation on the horizon given the jump in the CPI and slump in manufacturing (e.g- Empire State Index and Industrial production)?

Scott Grannis said...

I see some rising inflation, but the manufacturing slump seems closely related to the supply-chain disruptions which have followed in the wake of the Japanese tsunami, and thus it is likely to be only temporary.

Public Library said...

As you pointed out many times. these are a few of the many signs of accommodative monetary policy.

There cannot be a general rise in the price of all goods without the expansion of the fiat money base. If people understood this, they would understand the Fed is behind the many disasters past, current, and soon-to-be future.

Lets not forget the 70's stagflation was in part a result of the Feds expansion for Nixon's reelection effort...

Benjamin Cole said...


At the risk of cherry-picking, the CPI-core rate for the last 12 months (not six months) is 1.5 percent.

When did we develop some sort of inflation fetish in America?

1.5 percent and we say the Fed is accommodative?

BTW, many say the CPI-core overstates inflation, perhaps by one percent. If so, we are at 0.5 percent for the last year.

So, just how low should we go?

Do the words Bank of Japan mean anything to anybody?

scharfy said...

Wish you could elaborate on the transmission mechanism between cheap bank reserves provided by the Fed and inflation? Doesn't flatlining credit growth debunk your theory?

Policy might be easy, but there's no loan growth. Its a difficult argument to make that the Fed is behind CPI at 2%.

The spike in owner rent equivalents from people renting instead of buying seems to be driving CPI, along with oil/ commodities.

Gonna be tough to get sustained core CPI moves with median incomes flat and unemployment @ 9%

Wait till the Headline CPI numbers start rolling over....

I think Bob McTeer has it right

Scott Grannis said...

scharfy: I have been posting on the subject of monetary policy for a long time. See this post, for example:

It's possible to have a moderate rise in inflation even with modest growth in the M2 money supply.