Inflation: Distorted by the Past
Misinterpretations of what CPI and PCE measure keeps us unnecessarily concerned about the future.
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It's been 4 months since our last article on inflation in the US. Inflation is still a prominent topic in the media, which has focused on some of the continuing ‘high’ inflation rate data we have seen over the last 4 months. The most recent Consumer Price Index for April came in at 0.3% month-over-month (3.4% over the last 12 months). Many market opinions and comments have focused on this number, worrying that inflation, which is still above 2%, might spiral out of control. We will describe why inflation data suggests that inflation is under control, and the Federal Reserve in the US appears to agree with this interpretation.
Inflation – The Data
“Inflation”, as commonly discussed, is a variable that captures how much overall prices in an economy have increased over a specific time period. To try to get at this “inflation”, economists have designed many measures such as the Consumer Price Index (CPI) and Personal Consumption Expenditure Price Index (PCE or PCEPI). Below are the recent trends in these measures on a 12 month basis:
The concern is that these measures are showing inflation above the target of 2%. But, as we discussed in one of our recent articles, we shouldn’t just take measures at face value, but critically assess whether they are capturing what we actually are trying to get at.
Inflation – Adjusted for Shelter
The US measures of inflation – CPI and PCE – take into account shelter inflation. Shelter inflation is the price of the service a house provides. For many renters, this is a true cost. But the problem with the shelter measure is that it is not reflective of what is happening currently. Due to the way rent data is collected (once every 6 months per house that is in the CPI sample), the shelter inflation measure is heavily lagged. That is, we are capturing inflation that happened many months ago, but the CPI and PCE are only ‘recording’ it now. So even if today rents would fall, we would not see this in the CPI and PCE for at least 6 months, if not longer (this is due to the fact that rent leases are usually locked in for a year).
This creates a false impression that inflation is elevated today, when in reality, it might not be and we are just documenting ‘historic’ inflation. The chart below shows inflation if we were to completely exclude the shelter index:
It is also worth pointing out that inflation measures are not standardized across countries. The US inflation measure contains the imputed value for owner-occupied rent (Owner Equivalent Rent – OER). For the Euro area, the Harmonized Index of Consumer Prices (HICP) does not include OER (it does include rent that represents less than 6% of EU HICP, while OER + rent represent 36% of US CPI) and thus, has a much lower current inflation reading. Below is US inflation measured using the European HICP method:
The reason it may be appropriate to disregard shelter from the inflation measure is the fact that market rent data, which is more current, suggests a much lower increase in rent inflation than the CPI measure.
Federal Reserve – Agrees with Nominal News
On May 1, 2024, the Federal Reserve announced in its interest rate policy meeting that the interest rates will remain at the 5.25% to 5.5% range. However, the Federal Reserve did make another announcement – that it will reduce the rate of quantitative tightening.
Quick Aside – What is Quantitative Tightening and Quantitative Easing
Beyond interest rates, the Federal Reserve has another tool at its disposal to control inflation and economic activity – the purchase and sale of various high quality assets. To increase the amount of money in the economy, the Federal Reserve can purchase assets such as US Treasuries (government debt) and Mortgage Backed Securities (multiple mortgages packaged into one). In this transaction, the seller of the asset, like the US Treasury, receives money today from the Federal Reserve, rather than waiting for the asset to mature in the future. Since the seller of the asset now has cash, they can re-invest in the economy, stimulating demand (and possibly inflation). This process of buying assets by the Federal Reserve is called Quantitative Easing (QE). The reverse transaction – that is, the Federal Reserve selling these assets back to people, is called Quantitative Tightening (QT). Via QT, the Federal Reserve can reduce the amount of money in the economy, reducing demand and thus, reducing inflation.
The Federal Reserve Reduces QT
On May 1, the Federal Reserve announced that it will reduce its QT from $60bln to $25bln a month. That means instead of selling $60bln of its assets to the market, it will now sell only $25bln. This means the economy will have $35bln more of cash each month than before. As described above, this means the Federal Reserve is choosing to stimulate the economy a bit. As this move is ‘pro-inflationary’ (as there is more money in the economy), it implies that the Federal Reserve is not concerned about inflation spiking, and if anything seems to think the risk is to the downside in the economy.
Separately, on Tuesday, May 15, 2024, Federal Reserve Chairman Jerome Powell during a meeting, mentioned that he has been somewhat surprised by how rent inflation has developed – “Housing inflation has been a bit of a puzzle”. He appears to still expect shelter inflation to fall based on market data.
Inflation Trend Going Forward
There is little to suggest that inflation will re-accelerate. It will continue to drop without any additional intervention by the Federal Reserve, especially as shelter inflation data gets updated for the current rental data. Over the last 12 months, according to Zillow, rents have gone up by 3.6%, while the April 2024 CPI measure had it 5.5%.
It is important to understand that CPI and PCE are simply tools used to inform our understanding of what is happening with “inflation”. Without analysis and consideration, however, these tools can be mis-used and mis-interpreted.
Inflation Nowcasting
Forecasting inflation measures (that is, what CPI and PCE numbers will come in at) over a long horizon is still a bit of a difficult process. The Cleveland Federal Reserve posts Inflation Nowcasts to try and predict current CPI and PCE measures rather than waiting till the month is over (CPI is usually published 2 weeks after the end of the month, while PCE is published almost 1 month after the end of the month). You can always see the current prediction from the Cleveland Federal Reserve model here. Here is the prediction for the month of May:
The month-over-month value is the increase in prices over the month. The current month-over-month PCE estimate of 0.12% would imply an annualized inflation rate of 1.45%. On a year-over-year basis, if May comes in at 0.12%, then since last May, the PCE measured inflation would be at 2.69%. The year-over-year rate is the PCE estimate over the last 12 months including May.
This model has its limitations. The Cleveland inflation estimates mainly rely on recent CPI and PCE data to forecast current month’s inflation for many categories such as goods and services. Thus, it does not incorporate too much data from the current month. One data source that it does use that is current is the price of oil and car gas. The Cleveland model uses weekly data for this. That is why the CPI/PCE estimate for the month of May is so low – oil prices from April dropped.
Bonus Topic – Inflation and Tariffs
On May 14, 2024, President Joe Biden announced a new policy that imposes significant tariffs on imports from China of electric vehicles, steel, lithium-ion batteries and solar cells among other things. These tariffs are quite large – ranging from 25% to 100% of the price of the imported goods. However, the volume of the tariff affected goods is not large – at $18bln (total imports from China amount to approximately $420bln). A significant online debate has transpired wondering whether this decision will increase inflation or not. This is where economics research and modeling is helpful to think things through.
Veteran readers of Nominal News may recall the discussion we had on the New Keynesian model. To summarize it, the New Keynesian model tells us that the rate of inflation is directly linked to the real marginal cost of production (cost to produce the next unit of a good) and desired mark-ups (profit margins). If firms were buying materials, such as steel, from China because it was cheaper to do so, this will now imply a higher real marginal cost of production, since the input materials will now be costlier after the tariff. In turn, this means that the rate of inflation will be higher, holding all else constant (other input costs remain the same and desired markups remain the same). This is what the New Keynesian model tells us should happen in the economy. Overall, the tariffs will increase real marginal cost, but due to the limited volume of trade being impacted, we would not see much of an inflation spike.
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Thanks for breaking down some of the issues surrounding inflation measurements. Maybe you've addressed this before, but isn't another reason why the current numbers should not be too concerning the fact that the Fed's inflation target is an AVERAGE over time? With inflation below 2-percent for most of the 2010s, we need inflation above 2-percent now to satisfy the targeted long-run average.
As you (correctly) note, the Biden tariff hikes will not move the needle much on inflation. That said, the broader protectionist movement by American politicians and the “normalization” of tariffs is definitely not helping address high inflation.
We didn’t need more tariffs on cars or batteries right now, just look at the prices at the dealer lots.