Inflation: Soft but Stable?
We have experienced a dramatic disinflation—a slowing in the growth rate of inflation—over the past couple of years, with the 12-month growth rates of several measures of underlying inflation trends falling from around 3.0 percent in mid-2008 to lows not seen in nearly five decades. In fact, over the past year, measures of underlying inflation produced by the Federal Reserve Bank of Cleveland—the median CPI and 16 percent trimmed-mean CPI—are up just 0.6 percent and 0.9 percent, respectively. With measured inflation rates that low, speculation abounds that disinflation will eventually give way to deflation. A quick glance at the most recent report on consumer prices might splash some cold water on that discussion. But then, a deeper dig through the report reveals details that might support continued low rates of inflation.
The overall CPI jumped up 3.8 percent in July, though that rise was driven largely by a large spike in energy prices. Excluding food and energy prices (the core CPI), the index rose 1.6 percent during the month and is now up 1.7 percent over the past three months, a far cry from its growth rate of −0.2 percent over the first three months of this year. There have been some noisy price movements over the past few months bolstering those relatively higher core readings. For example, an increase in tobacco taxes pushed up tobacco prices, and prices in various apparel categories jumped around in a volatile fashion (likely symptomatic of seasonal adjustment or mismeasurement issues). Implicitly, the core CPI takes all price changes in a given month except for food and energy prices as a signal of underlying inflation.
The Federal Reserve Bank of Cleveland’s trimmed-mean measures, which were designed to lessen the impact of extreme component price swings on the reading of underlying inflation, usually clear up the picture that can sometimes be muddled by the core CPI. Unfortunately,Â while the median and 16 percent trimmed-mean measures have been running softer than the core CPI over the past three months (0.8 percent versus 1.7 percent), they disagreed by a full percentage point in July. The median CPI rose 0.8 percent during the month, while the 16 percent trim increased 1.8 percent. So, which measure should we believe this month?
|Percent change, last|
|1 mo.a||3 mo.a||6 mo.a||12 mo.||5 yr.a||2009 average|
|Consumer Price Index|
|Less food and energy||1.6||1.7||1.1||0.9||2.0||1.8|
|16% trimmed meanb||1.8||0.8||0.6||0.9||2.2||1.3|
- a. Annualized.
- b. Calculated by the Federal Reserve Bank of Cleveland.
- Sources: U.S. Department of Labor and Bureau of Labor Statistics.
To help us answer that question, we need to employ another measure of inflation that combines the disaggregated data in a different way. Recent work by Mike Bryan and Brent Meyer (here), separates the components comprising the overall CPI into flexible and sticky goods. They find that flexible-priced components tend to be very noisy and can easily respond to changing economic conditions, while sticky-priced components tend to be more forward-looking and better indicators of future inflation.
One way to think about sticky prices is that, for some goods and services, it is costly to change prices frequently. The classic example is menu costs: It is costly for restaurants to continually print new menus, so they set their prices infrequently (when is the last time prices changed on McDonald’s dollar menu?). In order to maintain profits in between price changes (or at least produce above marginal cost), price-setters likely incorporate expectations of future inflation into their pricing decisions today. We may be able to exploit this aspect of pricing behavior when trying to calculate underlying inflation trends.
Recently, the growth rate in the sticky CPI has been quite soft relative to its longer-term (five-year) trend growth rate of 2.3 percent. Also, compared to the core CPI, the sticky CPI has been on a sharper disinflationary path over the last two years—falling from a 12-month growth rate of 3.1 percent in mid-2008 to just 0.8 percent as of July (a series low with data back until 1968). Moreover, in July the sticky CPI rose 0.9 percent, consistent with its near-term trend, while the flexible CPI jumped up 11.4 percent after three consecutive monthly declines. After stripping away food and energy prices from the flexible price series, it still rose 5.2 percent in July and is up roughly 6.0 percent over the past three months, compared to its three-month annualized growth rate of −0.1 percent through the first three months of this year. Based on this evidence, it seems that the price increases from the more volatile flexible price series have been putting upward pressure on some underlying inflation measures, while the sticky-price series has continued on its subdued (but positive) inflation trend.