Thursday, 19 of April of 2018

Economics. Explained.  

Consumer Price Index

April 11, 2018

The CPI fell 0.1% in March after having risen 0.2% in February.  During the past year the CPI has risen 2.4%.

Food prices rose 0.1% in March after having been unchanged in February.  Food prices have risen 1.3% in the past twelve months.

Energy prices declined 2.8% in March after having edged upwards by 0.1% in February.  These prices are always volatile on a month-to-month basis.   Over the past year energy prices have risen 7.0%.  The recent run-up in energy prices seems to reflect strengthening GDP growth around the world which is bolstering the demand for both crude oil and gasoline.  However,  U.S. production is surging and inventory levels have begun to climb.  As a result, oil prices have recently declined from about $68 per barrel to about $65.   The Department of Energy expects oil prices to average $55.33 in 2018 significantly lower than where they are currently.

Excluding food and energy the CPI rose 0.2% in both February and March.  Over the past year this so-called core rate of inflation has risen 2.1% but in the past three months it has accelerated to a 2/8% pace.  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 0.3% while prices for services have risen 2.9%.

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 1.3%, appliances 2.2%, televisions 14.3%, audio equipment 17.6%,  toys 8.5%, information technology commodities (personal computers, software, and telephones) 3.2%.  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 retailer.

In sharp contrast prices of most services have risen.  Specifically, prices of services have risen 2.9% in the past year.  The increase in this  broad category has been led by shelter costs which have climbed 3.3%.  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, have been very well contained in the first half of this year we believe that as the year progresses the core rate of inflation will have an upward bias  because of what has been happening to both 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 1.6% rate but is poised 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 2.1%.  However, with the economy growing steadily, rents rising, and wage pressures climbing, the core inflation rate should pick up from 2.1% currently to  2.4% by yearend.  And because the core PCE increases at a rate roughly 0.5% slower than the core CPI, the core PCE should increase  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 1.7% and the year-over-year increase in the CPI at 2.4% the “real” or inflation-adjusted funds rate is negative 0.7%.  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

NumberNomics

Charleston, SC


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