The March CPI (Consumer Price Index) brought decidedly mixed news. Year-over-year, CPI inflation fell from 6% in February to 5% in March. Indeed, the year-over-year inflation rate has trended down since mid-2022. However, as we have pointed out in earlier posts, year-over-year measures of inflation are slow to reflect recent changes in trend since they are 12 month averages of past monthly inflation rates. The good news is that monthly (annualized) inflation is down from 4.5% (February) to 0.6% (March), well below the Fed’s 2% inflation target. A glance at the chart below will remind regular readers that monthly inflation rates exhibit considerable variability. Our preferred measure is the 3-month average of monthly inflation rates. This measure declined more modestly, from 4.1% to 3.8%. More importantly, the 3-month average inflation rate is still well above the Fed’s 2% target.
The news is decidedly worse when looking at core CPI inflation (that is, excluding the volatile food and energy components). On a year-over-year basis, core CPI inflation rose from 5.5% in February to 5.6% in March. On the other hand, the monthly core CPI inflation rate fell from 5.6% to 4.7%. Again, we prefer to look at the 3 month average to gauge the direction of trend inflation. The 3 month average of core CPI inflation fell slightly, from 5.2% to 5.1%. More troubling is that these measures are all well above the Fed’s 2% inflation target.
The producer price index (PPI) was released today that offered up a little more good news. The PPI fell 0.5% in March. Moreover, as noted by the BLS, “two-thirds of the decline in the index for final demand can be attributed to a 1.0-percent decrease in prices for final demand goods. The index for final demand services moved down 0.3 percent.”
Finally, short term inflation expectations have risen: For the one year horizon, from 2.1% in March to 2.6% in April; at the two year horizon, from 2.2% to 2.4%. These developments are, presumably, unwelcome by policymakers who are worried about higher inflation expectations becoming entrenched. Fortunately, the five year expected inflation rate fell from 2.2% to 2.1% while 10 year expectations dropped from 2.3% to 2.1%.
Overall, as mentioned at the outset, the news is mixed. Yes, the CPI is down. But, the year over year core CPI is up. The main reason for the difference between the CPI and CORE CPI is that energy prices fell: gasoline, down 17.4%, and fuel oil, down 14.2%. Given the highly volatile nature of food and energy it is useful to pay attention to the core measure.
Inflation as measured by the Consumer Price Index (CPI) was down, again, in December. The monthly change for the CPI in December came in at -0.079% after increasing 0.096% in November and 0.44% in October. The year over year change in December was 6.42% following 7.12% in November and 7.76% in October. (Since we use seasonally adjusted CPI data, our annual inflation rates differ slightly from the headline numbers that use unadjusted data.) In fact, since July the monthly annualized inflation rate consistently ran below the annual inflation rate, as shown in the figure below. Roughly speaking, the annual inflation rate is the average of the previous 12 months’ inflation rates. As a result, when the monthly inflation rates are below the annual inflation rate — as has been the case in the second half of 2022 — the annual inflation rate will fall. Conversely, when the monthly inflation rate exceeds the annual inflation rate, the annual inflation rate will rise, as it did between July 2020 and June 2022. This discussion implies that it will take another six months of low monthly inflation rates until the annual inflation rate will be reported to be low.
At this stage, it’s helpful to take a step back and ask: What exactly do we mean by “inflation”? In general, inflation refers to an on-going increase in the general level of prices. Operationally, inflation is typically measured by the percentage change in a price index like the CPI, Core CPI (the CPI excluding its more volatile food and energy components), or the Personal Consumption Expenditure (PCE) price index, to name but three. As shown in the next figure, over long horizons, these three measures of inflation tend to move together.
A couple of issues arise. First, over what horizon should inflation be computed? Since inflation is an ongoing process, monthly inflation rates don’t do the trick since they’re far to volatile (see the first chart above). While annual inflation rates are much smoother than their monthly counterparts, annual inflation rates are slow to reflect changes in trend as in the second half of 2022. A simple rule like “Use a three or four month average of the monthly inflation rates” is tempting, but arbitrary. It is, perhaps, best to look at both annual and monthly inflation rates and apply some judgement.
A second issue is that a once-and-for-all increase in the price level is not really “inflation” in the sense of a continuing increase in the price level. However, the (annual) inflation rate as computed from, say, the CPI will record higher inflation following such a one-time change in the price level. Indeed, such a change in the price level will lead to an increase in reported inflation for 12 months. The relevance of this second issue is that the war in Ukraine pushed up global food and energy prices. To the extent that these price increases are permanent, they do not contribute to inflation (on-going increases in prices), although they raise measured inflation. To be sure, core CPI inflation (that is, stripping out the food and energy components) has been lower than overall CPI inflation. Comparing the monthly inflation rates for the CPI and core CPI reveals that monthly core CPI inflation is less volatile. In the event, at least some of the increases in food and energy prices owing to the Ukrainian war have proved to be temporary. Falling food and energy prices in the second half of 2022 have contributed to the decline in monthly CPI inflation. As shown in the chart below, monthly core CPI inflation continues to run well above the Fed’s stated 2% inflation target.
A Quick Primer on Price Level Measurement
The idea of inflation measurement is to uncover a general rise in prices in an economy. The two that garner the most attention, the Consumer Price Index (CPI) and the Personal Consumption Expenditure Index (PCE). The Bureau of Labor Statistics (BLS) calculates the CPI (see the technical note here):
The Consumer Price Index (CPI) measures the change in prices paid by consumers for goods and services. The CPI reflects spending patterns for each of two population groups: all urban consumers and urban wage earners and clerical workers. The all urban consumer group represents about 93 percent of the total U.S. population. It is based on the expenditures
of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired people, as well as urban wage earners and clerical workers.
The CPI is a “cost of living” index as it uses spending patterns of urban consumers:
In calculating the index, price changes for the various items in each location are aggregated using weights, which represent their importance in the spending of the appropriate population group. Local data are then combined to obtain a U.S. city average.
The BLS also reports the “CPI less food and energy,” the CPI-X. The reason for omitting food and energy is that these prices are very volatile and have a large influence on the measure of the CPI because of the larger weights associated with them. For those interested, here are the current weights.
The PCE is calculated by the Bureau of Economic Analysis (BEA) that is also responsible for calculating GDP. According to the BEA:
BEA’s closely followed personal consumption expenditures price index, or PCE price index, is a narrower measure. It looks at the changing prices of goods and services purchased by consumers in the United States. It’s similar to the Bureau of Labor Statistics’ consumer price index for urban consumers. The two indexes, which have their own purposes and uses, are constructed differently, resulting in different inflation rates.
The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and for reflecting changes in consumer behavior. For example, if the price of beef rises, shoppers may buy less beef and more chicken. Also, BEA revises previously published PCE data to reflect updated information or new methodology, providing consistency across decades of data that’s valuable for researchers. The PCE price index is used primarily for macroeconomic analysis and forecasting.
These are not the only two, however. The Cleveland Fed produces the median CPI and the 16% trimmed mean. Recall that the main idea is to capture a general rise in prices. Removing highly volatile changes, or outliers, better reflects this general rise. Note that the median measure has been stuck at 7% for the last three months.
