What's Up with Inflation?

Nathan and Brad are known troublemakers. The rest of their gang is well-mannered and even-keeled. I soon learned that I could understand and predict the behavior of the whole group by focusing mostly on Nathan and Brad. If Nathan had a few too many JDs the night before, then the gang would be quiet and slow the next morning. If Brad had been turned away from Night Moves the night before, the gang would be surly over Eggs Benedict.

That’s my take on inflation. Let me explain. The Fed awakened from its midsummer's night dream of slaying the unemployment dragon to discover inflation. Responding to an inflation rate in early 2017 that approximates the Fed’s goal for inflation, the Fed mightily raised the Fed Funds Rate by 0.25 points to a towering 1%. As my followers know, I have consistently implored the Fed to raise rates, so I should be happy. But alas, an economist rarely finds solace, much less happiness, as a practitioner of the dismal science. The rub here is that the Fed is doing the right thing for the wrong reason.

Returning to my opening paragraph, imagine that the gang started acting out. Someone not experienced with the gang would immediately point out the gang’s improper behavior and impose a harsh regulatory regime on all the gang members. But someone with more information would readily know the real cause of the problems – Brad and Nathan. As such, the appropriate remedy would focus on those two and not the innocent, sweet rest of the gang.

Okay, I am ready to be more specific. The Nathan/Brad nexus for inflation is the inflation behavior of two of the hundreds of prices of goods and services we buy in this country –  food and energy. The Fed has mistaken movements in the overall US inflation rate with changes in the prices of F&E. This mistake matters a lot – the remedies for a general rise in the nation’s inflation rate are very different than those associated with food and energy. For example, a policy to restrain buying of all goods and services might impact the prices of F&E. But surely that would be overkill as it would “punish” the whole gang of prices when they had little or nothing to do with the higher inflation.

Back up, Larry. What is inflation, and why are we concerned with it? Inflation is another one of those macro-thingies. Inflation measures how much the national price level is changing. Since most of us hate it when the price of JD or other necessities rise, we wonder about the course of the prices of most of the things we buy. Luckily, the Labor Department publishes the CPI each month, and we can oooh and ahhh about its ups and downs. When it goes up, we curse. When it goes down, we go to Tacos Guaymas and drink Tequila until we get acid reflux.

But it is not that simple. Sometimes a rise in the inflation rate is accompanied by rising employment and wages. That doesn't sound so bad. Sometimes it is associated with rising unemployment or what we call stagflation. That is not so good.

And worse yet, the CPI numbers are averages over many consumers. The last time I looked I was not the average consumer buying average stuff. In fact, if you know the average consumer, please have her give me a call. When the Labor Department constructs the CPI, they average together prices of food, beverages, fuel, recreation, education, Uber rides, and bunches more. But they don’t average all this equally. The prices of men’s golf shoes might have gone up by 1000% this month but men’s golf shoes are a very tiny part of what the average consumer typically buys each month – so 1000% has a very small weight and little influence over the CPI.

Here are some of the weights used to produce the CPI on various spending categories:

            Food and Beverage  .15

            Shelter                        .34

            Apparel                       .03

            Fuel for transport      .03

            Medical                       .09

So when the Labor Department averages prices in a given month, they pretend that the average person spent 34% of her income on shelter and 15% on food and beverages. Now let’s suppose you are on a diet that month and decided to live in a teepee. That month you spent a ton of money on your hair and nails and very little on everything else. Guess what. The price level may have gone up 3% for the average dude, but for you that would be very misleading.

General point. Inflation is a macro phenomenon and any month’s reading might have very little to do with changes in your welfare. The devil is in the details.

Let’s get back to the Fed. I looked at the data, and I think the lens is pretty fogged up. The Fed is mistaking an energy thing over which it has no control with a macro thing. They worry that inflation is rising but mostly what is happening in 2017 is that price change is returning to normal. From 2013 until the end of 2016, changes in macro inflation were almost totally driven by changes in food and energy. To be more precise, F&E were declining and were dragging down the average of all prices. Those low national inflation rates were not driven by national macro factors but instead by sectoral impulses originating in the food and energy components. Those impulses bottomed in August of 2016 and then turned marginally positive in 2017.

To be more explicit, what I did was look at the ratio of F&E inflation as a percent of total inflation (which includes F&E and everything else we buy). I won’t bore you with every month but below are a few data points from 2016 and 2017. In February of 2016, the annual inflation rate (from March 2015 to February 2016) was 1%. That’s a very low rate of inflation. But notice that prices of F&E were down 1.4% during that year. Thus the overall inflation rate was low because of the drag by F&E. You see similar results for most of 2016.

            Month               Inflation   F&E

February                   1.0      -1.4

            March                        0.9      -1.3

            September                1.5      -0.7    

For 2017, we have two months of data for January and February. Notice the much higher annual inflation rates in those two months. That’s quite a swing. But notice even more the swings in F&E from negative to positive change. For example, from September to February, the swing in the overall inflation rate was +1.3 points (1.5 to 2.8). The swing in F&E was from -0.7 to +0.6 or about + 1.3 points. Hmmm.

Month               Inflation   F&E

January                     2.5      0.3

            February                  2.8      0.6

Just in case you think I am cheating, the Labor Department publishers the CPI less F&E which tells you how much the prices of non-F&E goods and services change. Non-F&E prices seem to be stuck at about 2.2%. Over the 15 years from 2002 to 2016, they averaged about 1.9% per year. Is inflation higher in 2017, maybe a smidge.

Month               CPI w/o F&E

February 2016          2.3

March                        2.2

September                2.2

January 2017            2.3

February                    2.2

Point? Over the last several years, Brad and Nathan have been acting up like it’s Mardi Gras while the rest of the gang have been sleeping like babies. With regards to the overall economy, nothing much has changed. The Fed can’t do anything about food and energy prices. It should focus on creeping inflation of non-F&E prices but by no means is any of this heart-stopping. The Fed knows it should return its policy to normal. The recent rise in the inflation rate has nothing to do with all that. Interest rates of 1.0% are not normal. Gradually raise those rates and forget the inflation nonsense.