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November 21, 2008

Thoughts on reading the October CPI

Here is what we know about the October consumer price index (CPI). The overall index declined at an annualized rate of about 11 percent for the month—it’s sharpest fall since 1947. A plunge in gasoline prices played a big part in the decline, but that isn’t the whole story. The traditional “core” CPI, which excludes food and energy prices, also declined in October (at an annualized rate of about 1 percent). This is the first decline in the core CPI since 1982.

Let me offer an opinion on what may be behind these numbers. The drop-off in consumer prices seems to have been prompted by a number of factors, including some pass-through from sharply lower commodity prices, a stronger dollar (which makes import prices cheaper), and very soft consumer spending.

But here’s what I don’t know. Is the October CPI a sign of “deflation"? (and it would appear that many of you are interested in finding an answer to this question). Before you answer the question for me, consider the following: In order to be “deflation” the decline in prices has to be sustained and broadly based. And I’m not sure I can give you much guidance on how long the decline must be in order for it to qualify as sustained, and I sure can’t tell you how broadly-based a general decline in prices is. Consider the distribution of CPI component price changes in figure 1. About one-third of the prices in the CPI market basket declined last month, which is a fairly large percentage of the index. On the other hand, about one-third of the price index was rising in excess of 3 percent last month.

Distribution of October CPI Component Price Changes

One of the things I like to consider when thinking about how “sustainable” and “general” the monthly CPI data are is to consider the behavior of the trimmed-mean estimators of the CPI. A trimmed-mean estimator is the weighted average of the CPI after some proportion of the extreme values of the index are “trimmed” away. The idea of the trimmed-mean estimator is that extreme price changes are not representative of prices in general. Moreover, there is ample evidence that the more extreme the price change, the less sustained it is likely to be.

We can trim any proportion of the data away. In fact, we can trim it all away such that only the median price change remains (this is the Cleveland Fed’s median CPI series.) Consider figure 2, which shows all the various trimmed mean estimators of the October CPI data, from a CPI that trims very little of the index to one that trims away most of the index. How much trimming provides the best perspective from which to judge how sustainable and general the monthly price data are? In the past, I’ve argued that two indicators stand out, the 16 percent trimmed-mean CPI (trimming 8 percent of the most extreme highs and 8 percent of the most extreme lows from the data) and the median CPI. I’ve highlighted these values in figure 2. While the overall CPI posted a sharp decline, the 16 percent trimmed-mean CPI posted a rather slight 0.6 percent decline, and the median CPI rose 1.8 percent.

Trimmed Mean Estimators (Oct 2008)

But, admittedly, knowing which trim of the data best represents how sustainable and general a monthly price report is, is not very clear. So let me offer up a range for you to consider: the interquartile range of the trimmed-mean estimators. An interquartile range is merely the spread between the 75th and the 25th percentile of the estimators. As such, it provides a relatively stable spread of the estimators from which to gauge the range over which prices are “generally” rising (or falling.) Figure 3 shows the interquartile range of the various CPI trimmed-mean estimators monthly since 2004 compared to the traditional core CPI. The interquartile range of the October CPI data is from 0.5 percent to 1.5 percent, shown as the last vertical line in figure 3, and 1.5 percentage points above the core measure.

Core CPI and the Interquartile Range of Trimmed-Mean Estimators

So when the boss asks me what I thought of the October CPI report and what does that single number tell us about inflation (or deflation), my answer is this: The overall and the core CPI posted declines for the month and clearly there is significant, rather broadly based downward pressure on retail prices. But as I cut the data, it looks to me that the October CPI data is pointing to an inflation rate somewhere in the 0.5 percent to 1.5 percent range.

By Mike Bryan, vice president in the Atlanta Fed’s research department

November 21, 2008 in Data Releases , Inflation | Permalink


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Inflation (and deflation) is a monetary phenomenon. Price changes are not the cause, they are the effect. The CPI does not "point" to anything, it is a snapshot of what has happened.

Deflation = a decrease in the money supply. It has nothing to do with the CPI.

Posted by: Dirtyrottenvarmint | November 21, 2008 at 03:51 PM

Mike, RE: "In order to be “deflation” the decline in prices has to be sustained and broadly based. And I’m not sure I can give you much guidance on how long the decline must be in order for it to qualify as sustained ...."

This sounds eerily like the FED's position on the rampant inflation we witnessed over a four year period (that the FED failed to report).

Isn't it time for the FED to reconsider the efficacy of its economic monitoring & reporting methodologies?

Posted by: bailey | November 23, 2008 at 05:10 AM

Trimming the mean is just fine in average times. But it brings unnecessary smoothing to catastrophic changes and thus fails to predict horrific (3 or more sigma) outcomes until it is too late.

Consider the danger of trimming the mean of a series of plunging barometric readings just before a hurricane. You will miss the whole picture before it is too late to avoid catastrophic damage.

The absolute, complete and total collapse in consumer demand worldwide corresponds to the collapse in barometric pressure just before a tornado.

Where the deflationary tornadoes will touch down is difficult to predict. But they are highly likely.

I couldn't believe it when I read the entire FOMC minutes for October. There is NO governor who comprehends the imminence and magnitude of the deflation risk we face.

I am fully persuaded that we will have at least a 7 percent price drop year over year; yet no Governor agreed with that.

One of the reasons is because of "trimming the mean" and other statistical techniques that assume that our outcomes and growth generally follow Gaussian distributions.

We are not reverting to the mean any time soon.

Matt Dubuque

Posted by: Matt Dubuque | November 24, 2008 at 10:25 PM

Dirtyrottenvarmint, the definition of deflation and inflation is open to debate, of course, but you can't blast Mike for using the words in the way they are curretly used most widely. If you want to talk about monetary deflation, I recommend that you qualify it with just the adjective "monetary" and speak of Mike's deflation as "price deflation".

That said, I agree with you that we have been living in a monetary deflation for some months now, and it seems only a question of time until price deflation follows.

Posted by: Peter T | November 24, 2008 at 11:29 PM

To decide on a useful definition of "deflation", you need first to ask what you plan to use it for. In the current context, deflation matters because deflation causes expected deflation, which causes real interest rates to increase (at the zero lower bound on nominal rates) which reduces the demand for newly produced goods and services, which causes a recession and more deflation.

So define "deflation" as falling prices of an index of newly produced goods (consumption and investment) weighted by interest elasticity of demand as well as composition of GDP.

Posted by: Nick Rowe | November 25, 2008 at 06:56 PM

I would like to second what Matt Dubuque said in his comment. Trimmed means are probably good predictors in average times because the CPI series is highly autoregressive. CPI is most likely to be similar to what it was last month and getting rid of some of the extreme portions of the price index enhances the CPIs predictive capability.

I think we all agree that these aren't normal times. The markets and our entire economy appear to be suffering severe dislocations which I would compare to the hysteresis of a phase transition. We'll eventually revert to a new stable period, but during the dislocation normal predictors are going to be less useful than in stable times. Given the giant debt binge the country has engaged in, and the massive federal interventions in all phases of the financial system, I would predict very unusual fluctuations in the CPI over the next few years. Tough times ahead for those piloting the monetary ship of state.

Posted by: uber_snotling | November 25, 2008 at 07:28 PM

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