September 12, 2019

The CPI rose 0.1% in August after having risen 0.3% in July..  During the past year the CPI has risen 1.8%.

Food prices were unchanged in August and rose 0.1% in both June and July.  Food prices have risen 1.7% in the past twelve months.  These prices tend to be lumpy with increases reported for a few months followed by several months of declining prices.

Energy prices fell 1.9% in August after having climbed 1.3% in July.  These prices are always volatile on a month-to-month basis.   Over the past year energy prices have fallen 4,4% which, given its weighting in the index, has subtracted 0.3% from the overall reading for the past year.  So, if energy prices had been unchanged, the CPI in the past year would have risen 2.1%.

Excluding food and energy the CPI rose 0.3% in June, July, and August.  Over the past year this core rate of inflation has risen 2.4%, but in the past three months the core rate has risen at a 3,4% pace.  We expect the core CPI will increase 2.5% in 2019 as higher prices on goods imported from China will push this index higher in the months ahead, and 2.6% in 2020.

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 risen 0.8% 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 been unchanged or fallen for almost every major category in the past year.  Apparel prices have risen 0.2%, new cars have risen 0.2%, televisions have declined 20.2%, audio equipment has  risen 3.1%, toys have fallen 6.9%, information technology commodities (personal computers, software, and telephones) have declined 4.3%.  Prices for all of these items are widely available on the internet and can be used as bargaining chips with traditional brick and mortar retailers.  But note how in the past couple of months more and more goods are no longer falling on a month-to-month basis.  Instead, they have stopped falling and are beginning to climb.  They are still climbing slowly to be sure, but there comes a time when these goods-producing forms are going to start raising prices.  We seem to have reached that  point.

In sharp contrast prices of most services have risen.  Specifically, prices of services have risen 2.8% 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.

The CPI, both overall and the core rate, will climb gradually  in the months ahead.  Steadily rising shelter prices, gradually rising labor costs, and higher prices on goods being imported from China will tend to boost the CPI.  But on the flip side, productivity gains are countering some of the increase in labor costs, and the internet is keeping a lid on the prices of goods.  We look for an increase in the core CPI of 2.5% in 2019 and 2.7% in 2020..

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.  We expect it to climb 1.9% in 2019 and 2.3% in 2020.  The Fed has a 2.0% inflation target.

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 pricey 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 should increase 2.5% in 2019 while the core PCE climbs 1.9%.  But in 2020 look for the core CPI to rise 2.7% while the PCE deflator rises 2.3%. That compares to the Fed’s targeted rate for the PCE deflator of 2.0%.

Given sustained growth in GDP growth this year and the inflation rate being close to target, there is no need for the Fed to alter the level of the funds rate.  However, Fed officials cut rates 0.25% at the end of July and they intend to drop rates another 0.25% this month.  Any further rate cuts will simply add fuel to the inflation pipeline.

Stephen Slifer

NumberNomics

Charleston, SC