Monday, September 14, 2020

Consumer inflation has averaged 2% for 18 years

Depending on how you measure it, inflation has been running 1.5 - 2% per year for the past 18 years. It's a mystery to me why the Fed feels it needs to be higher. I remain convinced that less inflation is always better than more inflation, and I'm not hung up on inflation always needing to be positive. Why should money always lose value relative to goods and services?

Chart #1

We have been living in a 2% inflation world for the past 18 years. Sometimes that fact gets obscured by the sheer volatility of year-over-year inflation, which has ranged from -2.1% to 5.6% in the past two decades. Super-volatile oil prices are largely to blame for this; having ranged from $19 to $140 per barrel over this same period. Chart #1 helps illustrate this. The blue line is the total CPI, whereas the red line excludes energy prices. The Personal Consumption Deflator, on the other hand, has been running a bit over 1.5% for the past two decades; it's fairly typical for the CPI to register more inflation than the PCE deflator, since the deflator is more responsive to shifts in consumer preferences (consumers, being generally smart and thrifty, shy away from high-priced items, preferring instead cheaper substitutes).

Chart #2

Ex-energy, the year over year change in the CPI has ranged from -.7% to 3.1%, as seen in Chart #2. Taking out food prices in addition (which would be the so-called "core" rate of inflation) would make a very small difference. Energy is much more volatile than food prices, so that is my preferred measure of underlying inflation.

Chart #3

As Chart #3 shows, over the past 18 years the CPI ex-energy rate of inflation has averaged 2.0% per year (note that the index is plotted on a log scale, so its constant slope is equal to a constant rate of growth, in this case 2% per year). It may come as a surprise, but over that same period the total rate of CPI inflation has averaged almost exactly the same. In fact, since 1957, when the x-energy version of the CPI started, both ex-energy and total CPI inflation have also increased by virtually the same amount (~ 3.6% per year).

The price of oil has been by far the most volatile of any commodity. Take out oil, and you get a much better idea of where things are going on a year-to-year basis.

Chart #4

Chart #4 is interesting since it shows how much energy costs have shrunk as a share of total personal consumption. Energy today is only 3.4% of personal consumption expenditures, whereas it was almost three times more in the early 1980s. Food and energy together account for 11.7% (food is 8.2%).

Chart #5

Chart #5 compares the price of oil to the prices of non-energy commodities. Note the relatively tight correlation between the two. More importantly, note how the scale for crude goes from 1.4 to 280 (i.e., crude prices have increased by a factor of almost 200 times!), while the scale for non-energy commodity prices increases by a factor of only about 6 ⅔. Huge difference, yet very correlated! This confirms my preference for non-energy inflation as the best measure for underlying inflation trends.

The August readings for the CPI (+2.1% ex-energy over the past year) should put an end to speculation that the economy's virus-induced collapse would result in deflation. It's likely the Fed won't tighten for quite some time, but there is no reason at all to worry that they need to be easier. If I had to bet, I'd say the next tightening comes before the market expects it; that is to say, I think the risks are skewed to inflation exceeding expectations over the next few years.


Bill Snarf said...

If there is a higher probability of rates going higher or even the belief then NORMALLY equities correct, as near zero rates is the main reason for these valuations. But the feds new policy is to let inflation run so how do equities respond? The longer the fed waits to tighten the greater inflation will be or the mkt celebrates a dovish Fed. Its been so many years since this scenario played out. Well before my time.

Tom Nugent said...

To complicate matters, the calculation of consumer price index leaves lots to be desired. For example, last year the biggest factor causing an increase in the index was money manager compensation. Apparently if the stock market goes up and investment managers get paid more because there salary is a function of a percentage of assets under management. I don't think that is an accurate factor in calculating inflation.

Art Cohen said...

Being wrong about inflation is part of the economics profession. Fact of the matter is that economists haven’t been able to formulate a good theory for inflation. Consequently, any prior is as good as noise in which case the best forecast is a simple ML estimate which would say that inflation tomorrow
is more likely to be like today.

Tom Nugent said...

Scott's exhibit on inflation over time and the impact that the price of oil since the oil embargo should be supplemented by how the price of oil works its way into virtually all prices (fuel charges by my trash company) that will tend to push the core prices higher.

Peter X said...

I found this article of interest in relation to inflationary expectations:

Unknown said...

Peter X: Thanks for the link from advisorperspectives. That was very well presented and enlightening.

Michael Meyers said...

Scott, You know why the Fed wants higher inflation — to inflate away the massive federal debt. That’s the only way out. Love you blog and have been reading every post for many years. Thanks for everything.

Benjamin Cole said...

For the last 40 years, I have been anticipating higher rates of inflation.

Oldsters might remember Lucy, the girl in the Charlie Brown comic strip, who every year yanked away a football as Charlie was about to kick it. Charlie never learned.

There are days I feel like Charlie.

steve said...

Higher inflation and higher bond yields; expectations that never seem to be realized. I suppose at some they will especially given the incredulous amounts the Federal government is spending.

Scott Grannis said...

Re "You know why the Fed wants higher inflation — to inflate away the massive federal debt." Actually, it doesn't even take higher inflation to inflate away the federal debt. There are many trillions of dollars of debt today that are trading at interest rates that are lower than inflation. Anyone who owns that debt is thus losing purchasing power every day. Lenders' loss is the borrower's (federal govt) gain.