Monday, 16 of July of 2018

Economics. Explained.  

Category » Inflation

Consumer Price Index

July 12, 2018

The CPI rose 0.1% in June after having risen 0.2% in both March and April.  During the past year the CPI has risen 2.8%.

Food prices rose 0.2% in June after having been unchanged in May.  Food prices have risen 1.5% in the past twelve months.

Energy prices fell 0.3% in June after having risen 0.3% in May.  These prices are always volatile on a month-to-month basis.   Over the past year energy prices have risen 11.7%.

The recent run-up in energy prices seems to reflect three factors.  First, GDP growth around the world has picked up which is bolstering the demand for both crude oil and gasoline.  Second, oil production in Venezuela has dropped to a multi-decade low level given the chaotic political environment in that country.  And third, the supply situation from Iran is now highly  uncertain given the likely re-imposition of sanctions against that country later this year.  As a result, the International Energy Administration projects that demand will exceed supply by about 0.5 million barrels per day between now and yearend.  As a result, oil prices recently climbed to about $74 per barrel.   However, U.S. production is surging.  It will climb about 15% this year and another 10% in 2019 which will make the U.S. the world’s largest oil-producing country.  At the same time OPEC is talking about gradually increasing its pace of production. A s a result, crude oil prices have dropped from $74 to about $71 per barrel currently and should continue to decline gradually between now and yearend.

Excluding food and energy the CPI rose 0.2% in both May and June .  Over the past year this so-called core rate of inflation has risen 2.2%.  Clearly, inflation is on the upswing.  The question is still one of degree..

The most interesting development in the CPI in recent years has been the dichotomy between the prices of goods (excluding the volatile food and energy components) and services.  For example, in the past year prices for goods have fallen 0.7% while prices for services have risen 3.0%.

With respect to goods prices, it appears that the internet has played a big role in reducing the prices of many goods.  Shoppers can instantly check the price of any particular item across a wide array of online and brick and mortar stores.  If merchants do not match the lowest price available, they risk losing the sale.  Thus, they are constantly competing with the lowest price available on the internet.  Looking at specific items in the CPI we find that prices have fallen for almost every major category in the past year.  New cars have fallen 0.5%, televisions 19.1%, audio equipment 14.5%,  toys 10.2%, information technology commodities (personal computers, software, and telephones) 4.2%.  Prices for all of these items are widely available on the internet and can be used as bargaining chips with a traditional brick and mortar retailers.

In sharp contrast prices of most services have risen.  Specifically, prices of services have risen 3.0% in the past year.  The increase in this  broad category has been led by shelter costs which have climbed 3.4%.  This undoubtedly reflects the shortages of both rental properties and homeowner occupied housing. Indeed, the vacancy rate for rental property is at a 30-year low. This steady rise in the cost of shelter  will continue for some time to come and, unlike monthly blips in food or energy, it is unlikely to reverse itself any time soon.

While the CPI, both overall and the core rate, will have an upward bias  in the months ahead because of what has been happening to shelter prices, gradually rising labor costs, and rising producer prices.  But on the flip side, the internet is keeping a lid on the prices of goods.  So while the CPI should edge higher in 2018, it is unlikely to explode.

The Fed’s preferred measure of inflation is not the CPI, but rather the personal consumption expenditures deflator, specifically the PCE deflator excluding the volatile food and energy components which is currently expanding at a 2.0% rate but is  likely to head higher.  The Fed has a 2.0% inflation target.  However, going forward we have to watch out for the steady increases in shelter which, as noted above, is being pushed higher by the shortage of both rental properties and homeowner-occupied housing.   Shelter is a long-lasting problem and given its 33% weighting in the CPI it will introduce an upward bias to inflation for some time to come.  We also have to watch rising medical costs(prescription drug prices in particular) and the impact of higher wages triggered by the shortages of available workers in the labor market.

Why the difference between the CPI and the personal consumption expenditures deflator?  The CPI is a pure measure of inflation.  It measures changes in prices of a fixed basket of goods and services each month.

The personal consumption expenditures deflator is a weighted measure of inflation.  If consumers feel less wealthy in some month and decide to purchase inexpensive margarine instead of pricy butter, a weighted measure of inflation will give more weight to the lower priced good and, all other things being unchanged, will actually register a decline in that month.  Thus, what the deflator measures is a combination of both changes in prices and changes in consumer behavior.

As we see it, inflation is a measure of price change (the CPI).  It is not a mixture of price changes and changes in consumer behavior (the PCE deflator).  The core CPI currently is at 2.2%. We expect it to continue to climb at a 2.2% rate through yearend.  And because the core PCE increases at a rate roughly 0.5% slower than the core CPI, the core PCE should increase about 2.0% in 2018.  Both rates are beginning to trend higher.

Keep in mind that real short-term interest rates are negative.  With the funds rate today at 1.8% and the year-over-year increase in the CPI at 2.8% the “real” or inflation-adjusted funds rate is negative 1.0%.  Over the past 57 years that “real” rate has averaged about plus 1.0% which should be regarded as a “neutral” real rate.  Given a likely pickup in GDP growth this year and next and a gradual increase in the inflation rate, we regard a negative real interest rate inappropriate in today’s world.  The Fed should continue to push rates higher and gradually run off some of its longer term securities.

Stephen Slifer


Charleston, SC

Producer Price Index

July 11, 2018

The Producer Price Index for final demand – intermediate demand  includes producer prices for goods, as well as prices for construction, services, government purchases, and exports and covers over 75% of domestic production.

Producer prices for final demand rose 0.3% in June after having jumped 0.5% in May as energy prices surged.  During the past year this inflation measure (the red line) has risen 3.3%.  The PPI has been moving steadily higher.

Excluding food and energy producer final demand prices rose 0.3% in both May and June.  They have risen 2.8% since April of last year (the pink line).  This series has been steadily accelerating for the past two years.  Inflationary pressures are gradually re-surfacing.

This overall index can be split apart between goods prices and prices for services.

The PPI for final demand of goods rose 0.1% in June after having jumped jumped 1.0% in May. These prices have now risen 4.3% in the past year (left scale).  Excluding the volatile food and energy categories the PPI for goods has risen 0.3% in each of the past four months.  During the past year the core PPI for goods (the light green line) has risen 2.7% (right scale).

Food prices fell 1.1% in June after having risen 0.1% in May.  Food prices are always volatile.  They can fall sharply for a few months, but then reverse direction quickly.  Over the past year food prices have declined 0.9%.

Energy prices rose 0.8% in June after having surged 4.6% in May.  Energy prices have risen 17.0% in the past year.  These prices are also very volatile but the recent upswing seems to reflect a significant quickening of GDP growth around the globe, the cutback in global supply by OPEC, and a state of complete chaos for oil production in Venezuela.  However, U.S. oil output is now surging and OPEC is talking about an increase in its crude oil output.  Our sense is that the recent surge in energy prices will be at least be partially reversed between now and yearend.

The PPI for final demand of services rose 0.4% in June after having climbed 0.3% in May.  This series has risen 2.7% over the course of the past year (left scale).   Changes in this component largely reflect a change in margins received by wholesalers and retailers (apparel, jewelry, and footwear in particular).  The PPI for final demand of services excluding trade and transportation (the light blue line) increased 0.3% in June after having been unchanged in May.  It has climbed 2.3% during the past year.  This series, like the overall index, has been gradually accelerating for some time.

The recent increases in producer prices were foreshadowed by the results of the Institute for Supply Management’s series on prices paid by both manufacturing and non-manufacturing firms.  In the case of manufacturing firms the chart looks like the one below.  Price pressure were steadily building for six consecutive months.  Specifically, the price component rose steadily from 64.8 in November of last year to 79.5 in May.  The fact that every month was above 50.0 meant that prices producers were paying increased every single month.  The fact that the level of the index steadily rose during that period of time indicates that price pressures were intensifying every single month.  In June this series actually declined from 79.5 in May to 76.8 in June.  This means that prices continued to climb in June, but that the rate of increase was a shade less than in other recent months.  Hopefully, this means that the steady upward pressure on the PPI is beginning to abate.

And for non-manufacturing firms it looks like this.  The conclusion is largely the same.

In both cases, the run-up in prices was widespread.  It was not just energy prices.  Once again, we believe this escalation in the prices that producers are having to pay reflects stronger GDP growth around the globe.

Because the PPI measures the cost of materials for manufacturers, it is frequently believed to be a leading indicator of what might happen to consumer prices at a somewhat later date.   However, that connection is very loose.

It is important to remember that labor costs represent about two-thirds of the price of a product while materials account for the remaining one-third.  So, a far more important variable in determining what happens to the CPI is labor costs.  With the unemployment rate currently at 4.0%, the labor market is beyond full employment.  As a result, wages pressures have begun to climb, but much of the upward pressure on inflation should be countered by an increase in productivity.  Nevertheless, the tighter labor market should exert at least moderate upward pressure on the inflation rate.

Some upward pressure on labor costs, rents, and the cost of materials will put upward pressure on inflation.  We expect the core CPI to increase 2.3% in 2018 after having risen 1.8% in 2017.

Stephen Slifer


Charleston, SC

Gasoline Prices

July 11, 2018


Gasoline prices at the retail level rose $0.02 in the week ending July 9 to 2.86 per gallon.  In South Carolina gasoline prices tend to about $0.25 below the national average or about $2.61. The Department of Energy expects national gasoline prices to average $2.76 this year.  They are projected to peak right about now and then decline to $2.65 by the end of the year. 

Spot prices for gasoline have been on a steady upswing for the past several  months.  However, talk about OPEC increasing its crude oil output caused gasoline prices to decline about 9.5% since reaching a peak of $2.20 in late May.   But now, just days after the OPEC announcement the State Department sent both crude and gas prices, soaring by announcing it aims to eliminate most of Iran’s oil exports by the end of this year.

Crude oil prices recently jumped to $74 per gallon.  The recent run-up occurred instantly after Trump announced sanctions on Iranian oil exports.  The Energy Information Agency predicts that crude prices will average $64.53 in 2018.  If that is the case, oil prices should decline gradually in the second half of the year.

The number of oil rigs in service  However, the number of rigs in operation has  rebounded sharply in recent months to 1,059 thousand.  Thus,  higher crude oil prices are encouraging drillers to accelerate the pace of production.  If crude prices remain above $60 per barrel this year or higher, we should expect the number of oil rigs in operation, and production, to continue to climb.

Production has surged to 10,900 thousand barrels per day.  The Department of Energy expects production to average 10.8 million barrels this year but climb further to 11.8 million barrels in 2019.

To put those production levels in perspective, keep in mind that if U.S. crude oil production picks up as expected the U.S. will become the world’s largest oil producer by the end of this year.

How can the number of rigs rise slowly but production surge?  Easy.  Technology in the oil sector is increasing which allows producers to boost production while simultaneously shutting down wells.  A few years ago some frackers could not drill profitably unless crude oil prices were about $65 per barrel.  Today that number has declined to about $35 per barrel.  Six months from now that number will be lower still.

Oil inventories fell quickly for most of last year.    OPEC output was reduced at the same time that global demand picked up sharply.  While crude inventories have been sliding for a year, at 1,076 million barrels crude inventories are now roughly in line with the 2009-2014 average of 1,055 million barrels.  However, with demand continuing to slightly exceed supply for the next several months, stocks may well decline slightly further in the near term.

The International Energy Agency in Paris (IEA) produces some estimates of global demand and supply.  A couple of months ago its estimate had supply and demand relatively in balance between now and yearend.  But now,as shown in the chart below, demand picked up somewhat in recent months and while supply edged lower as production constraints have restrained output.  As a result the IEA now estimates that demand will exceed supply by about 0.2 million barrels per day between now and yearend. The IEA noted “chronic mismanagement” in Venezuela has cut production there to a multi-decade low,and Iranian production could slip further as a result of the U.S. sanctions.  And now there is the prospect of further curtailment in global oil supply by yearend stemming from curtailment of Iranian oil exports.

OPEC has chosen to boost output somewhat to counter the shortfall from Venezuela and Iran.  That would put demand in supply roughly in balance between now and yearend and allow the price of crude oil to decline somewhat.

Stephen Slifer


Charleston, SC*

Gross Domestic Purchases Deflator

June 28, 2018

There are many different deflators that are available.  This one is for gross domestic purchases which measures prices paid by U.S. residents.  It is the one measure of inflation that the Commerce Department talks about when it releases the GDP report.   It is our broadest measure of inflation and contains more than 5,000 goods and services.

The gross domestic purchases deflator rose 2.7% in the first quarter after having climbed by 2.5% in the fourth quarter. Over the past year this index has risen 1.9%.

Excluding the volatile food and energy components this index rose 2.6% in the first quarter after having risen 2.0% in the fourth quarter.

Remember that these deflators are weighted measures of inflation.  That means that when a builder switches from using copper pipe to PVC to save money, it registers as a price decline in these particular inflation measures.  Or when a consumer switches from buying butter to less expensive margarine the result is the same.  Thus, the deflator represents a combination of price changes and changes in consumer and business behavior.

The CPI, however, is a fixed basket of goods and services.  So what it shows are price changes only which, to us, is what inflation is all about.   We believe that the inflation rate is headed higher.  With the unemployment rate at 3.8% the economy is at full employment which should boost wages and, at last, that seems to be happening.  Both manufacturers and non-manufacturing firms are reporting sharply higher prices for their raw materials so commodity prices are also on the rise.  A very short supply of available rental properties is boosting rents.  Hence we expect  the core CPI to climb from 1.8% last year to 2.3% in 2018.  The one thing that is keeping the inflation rate in check is technology.  People are able to search the internet and find the lowest price available from Amazon or some other on-line website.  Thus, sellers of goods have absolutely no pricing power.  Prices of goods have fallen 0.3% in the past year while prices for services have risen 2.9%.

Stephen Slifer


Charleston, SC

Personal Consumption Expenditures Deflator

June 10, 2018

There are many different measures of inflation, but the one that the Federal Reserve considers to be most important is the personal consumption expenditures deflator, in particular the PCE deflator excluding the volatile food and energy components.

The PCE deflator rose 0.2% in April after having been unchanged in March.  The year-over-year increase now stands at 2.0%.

Excluding the volatile food and energy components the PCE deflator rose 0.2% in February, March, and April.  The year-over-year increase is now 1.8%.  This is the inflation measure that the Fed would like to see rise by 2.0%.   We think it will reach 2.0% by mid-summer and remain at the 2.0% mark for 2018 as a whole.  This inflation gauge has gone from being far below the Fed’s inflation target to being just below target currently.

The more widely known inflation measure, the CPI ex food and energy, has been rising at a somewhat faster pace and is projected to increase 2.4% overall n 2018 with a  2.4% increase for the core rate (excluding the volatile food and energy components).  For details of this forecast see the CPI write-up.

Why the difference?  The CPI measures price changes in a fixed basket of goods each month.  The deflator captures price changes, but also changes in consumer spending habits.  If we try to save money by switching from butter to lower-priced margarine, from beef to chicken, or if builders substitute PVC pipe for more expensive copper,  the deflator would come in lower than the CPI in that particular month.  For our money, we think that the CPI which strictly measures price changes is a better barometer of inflation.  The Fed disagrees.

Stephen Slifer


Charleston, SC

Employment Cost Index

April 27, 2018

The employment cost index for civilian workers climbed at a 3.3% pace in the first quarter after having risen at a 2.5% annual rate in the fourth quarter.  Over the course of the past year it has risen 2.7%.  Thus, the labor market continues to get tighter, and to attract the workers that they want firms are having to work employees longer hours, and offer higher wages and/or more attractive benefits packages.

With the unemployment rate at 4.1% and full employment also presumably at 4.5-5.0%, it is not surprising that we are beginning to see a hint of upward pressure on compensation.

Wages climbed at a 3.7% annual rate in the first quarter after having risen 2.2% rate in the fourth quarter.  Over the course of the past year wages have been rising  at a 2.7% pace.  Wage pressures are beginning to accelerate gradually.

Benefits climbed at a 3.0% rate in the first quarter after having risen 2.1% in the fourth quarter.   As a result, the yearly increase in benefits is now 2.6%.

What happens to labor costs is important, but what we really want to know is how those labor costs compare to the gains in productivity.  If I pay you 3.0% more money but you are 3.0% more productive, I really don’t care.  In that case, unit labor costs were unchanged.

Currently, unit labor costs  have risen 1.7% in the past year as compensation rose 2.9% while productivity increased by 1.1%.    As we look forward into 2018 we expect compensation to climb to about the 3.5% mark, but at the same time we expected productivity to rise by 1.8%.  Thus, unit labor costs at the end of this year are likely to be rising at a 1.7% which means that there will be only slight upward pressure on the inflation rate this year stemming from the tight labor market.  A 1.7% increase in ULC’s is clearly compatible with the Fed’s 2.0% inflation target.

Stephen Slifer


Charleston, SC