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June 13, 2011

Core cuts both ways

With the six-month average of annualized headline inflation running just over 5 percent, this Wednesday's consumer price index (CPI) report looms a little larger than usual. While it is dangerous to predict such things, there is every reason to believe that the measured increase in CPI inflation for May could be quite low. And there is every reason to believe that this softness will persist into June.

The reason is quite simple. Movements in gasoline and fuel prices really do push around the headline inflation number, and at long last it looks like that movement is in the downward direction. Here's the relevant picture:


Let's assume that, annualized, CPI excluding food and energy rises 2.1 percent, as it has so far this year, and food and nongasoline energy prices each rise at 5 percent. Then when you plug in gasoline prices already realized for May and EIA predictions for June, you get a 0.4 percent rise in the headline CPI in May and a 0.7 percent decline in June (both rates annualized).

Despite some probable relief on the headline inflation number, I remain aware of what that relief means and what it does not. Earlier in the year, Atlanta Fed president Dennis Lockhart had this to say:

"I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services…

"… The Fed, like every other central bank, is powerless to prevent fluctuations in the cost of living and increases of individual prices. We do not produce oil. Nor do we grow food or provide health care. We cannot prevent the next oil shock, or drought, or a strike somewhere—events that cause prices of certain goods to rise and change your cost of living."

Two points, then. First, even if things evolve as the chart above suggests, the level of gasoline prices will remain relatively high by recent standards. Low inflation readings for the next couple of months would therefore leave the cost-of-living high by recent standards, a fact that is not lost on us here at the Atlanta Fed.

Second, as President Lockhart's comments reveal, we were reluctant to attribute the run-up in fuel prices to monetary policy. And I imagine we will be equally reluctant to credit monetary policy with any relief from that trend.

In fact, I will fearlessly predict that, should our guess here about headline inflation in the next couple of months be proved accurate, we will point to core inflation measures as reason to look through some very low inflation readings. See these comments from President Lockhart's most recent speech for some additional perspective:

"Are the recent outsized increases in headline inflation the best signals of the inflation trend going forward? Or are other statistics—like core inflation or measures of inflation expectations—yielding a truer picture of what lies ahead?

"The answer matters a lot. And it certainly weighs heavily on my thinking. I would not hesitate to support an exit from our current policy stance if I believed that the headline inflation number of the past six months is really indicative of the underlying trend inflation rate. I don't believe this to be the case. And I am wary of tightening monetary policy in the face of quite ambiguous economic circumstances unless doing so is absolutely necessary to meet the FOMC's price stability mandate."

And here's why it matters, quoting President Lockhart from an interview with Reuters last week:

"In the interview, Lockhart said maintaining an easy Fed policy stance should ensure the moderate U.S. recovery does not fall off the rails."


"How high would the bar be for further Fed easing?

"It would take 'a significant deterioration as reflected in the overall economy, a set of deflationary signals and also unemployment numbers that rise dramatically. Last fall (when the Fed launched QE2), by some measures, we were seeing declining inflation expectations that were headed in a pretty negative direction, and that was happening pretty rapidly. We were in a disinflationary environment. So the risk of deflation was plausible. We acted and the situation has turned around. That was, at least in my way of thinking, very central to supporting the policy. We don't have anything remotely like a deflationary risk at the moment, short of a shock of some kind.' "

If what I suggest above—falling headline inflation, stable core inflation—comes to pass in the near term, don't expect me to start ringing the disinflationary bell.

This isn't the last word on the usefulness of core inflation statistics, and the debate is certain to rage on (see here and here, for recent installments). But I do hope that this post is remembered the next time the Federal Reserve is accused of hiding inflationary pressures behind the rhetoric of core.

Update: The May CPI report is in, and once again the facts trump arithmetic. We got the flip in the headline/core measures right; the rest, not so much.

Update: Here's one way to construct a synthetic CPI:


CPIHeadline(T) is the calculated value of the seasonally adjusted CPI in month T > December 2010. CPIHeadline(Dec2010) is the reported seasonally adjusted headline CPI for December 2010. CPIFood, CPICore, CPIGas, CPIOtherFuel, and CPIHHenergy are the seasonally adjusted component level CPI indexes for the above mentioned components. Note that this formula will not exactly replicate the January through April 2011 headline CPI since the components are not granular enough. When using the above formula to compute CPIHeadline(Apr11) and CPIHeadline(May11), we compute one-month headline inflation in May 2011 as the percent difference between the values of CPIHeadline(Apr11) and CPIHeadline(May11), both calculated with the above formula (i.e., do not use the reported value of CPIHeadline(Apr11)). In our calculations we used the same inflation assumptions for "other motor fuels" and "household energy" (both increase at a 5 percent annualized rate in May and June). By Patrick Higgins, an economist at the Atlanta Fed

David AltigBy Dave Altig, senior vice president and research director at the Atlanta Fed

June 13, 2011 in Deflation, Federal Reserve and Monetary Policy, Inflation, Monetary Policy | Permalink


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Can you share the exact equation to create headline inflation given Core, food and non-gas energy, and gas prices?

For example, assume core at 2.1%, assume food and non-gasoline energy go up at 5%, then plug in some gasoline price. Whats the exact equation?


Posted by: TC | June 13, 2011 at 10:12 PM

Dave thinks that we will have a negative print for CPI in June. I will wait and see if that happens. I doubt it.

I can't understand how Dave and the others at the Fed can push this kind of thinking. Bernanke has said several times that QE has brought us high stock values. The same forces that raise equities push up other asset classes as well. You can't get only "good" inflation when the printing presses are running and ZIRP is a three year long policy.

It would behoove the Fed to acknowledge their role in the run up in global inflation. When they try to deny the obvious connection they just lose credibility.

Posted by: Bruce Krasting | June 14, 2011 at 06:46 AM

Hi Bruce,

Read your work constantly and like it. Don't always agree, but it is good.

If oil falls to $90, we're going see negative headline CPI, period. There is a strong chance we will see far greater declines in the price of oil once Libya comes back on line. Germany just recognized the rebels as the legitimate government of Libya.

The headline inflation is being caused by a massive speculative bid under oil. This speculative bid in oil is very likely to get crushed. It could happen as soon as this week. Once that happens, then we're going to see a long string of negative CPI prints.

Posted by: TC | June 14, 2011 at 09:38 AM

TC - It's fairly straightforward to derive the weighting of gasoline from the example given.

The (rather straightforward) general calculation method is given by Wikipedia; specifics are maintained by the BLS.

Posted by: Ken Houghton | June 14, 2011 at 12:53 PM

TC. Tks.

Your comments on Libya and short term movements in crude make an excellent point:

The way we/the Fed measures inflation is flawed.

Yes, energy is a critical variable in the CPI. What is missing is how things are creeping up on us.

How about higher education? 25% per year sound right?

Health care Ins? At least 20% per year.

Transportation, clothing or rent? Try 10% in the last 6 months.

How about silly things like tolls or even traffic fines? 30%?

Seen the price for a bag of cement lately? Roofing shingles? Copper fittings? Nails? PVC pipe? It's across the board.

Food is off the charts. The Fed knows this. I'm sure that some of the folks who work there actually go to a store once in a while and sees what is going on.

But they have the nerve to tell us that things like an IPAD remaining stable in price while the CPU has increased is a net reduction to the real things we have to buy.

No sale. Sorry.

You may not agree with what I write. But consider the words from Bernanke way back in 2003. I wrote about it today. This blog brought on my effort. Forget my words. Focus on Ben's. In particular, the last quote in the article.

Posted by: Bruce Krasting | June 14, 2011 at 08:32 PM

Excellent work, David.

Could you explain the Fed's logic for requiring such a high bar on further monetary easing?

Suppose core inflation stayed roughly where it's at -- well below 2 percent, and unemployment stayed roughly where it's at, around 9 percent, perhaps coming down only very gradually.

You're saying the Fed's going to do nothing more in this case.

Is there a reason for that?

And, can you make a distinction between the Fed's strategy and the Japanese Central Banks' strategy circa 1993-2011?

@Bruce Krasting: If QE causes inflation in commodities, 1 for 1 increase in Excess Reserves notwithstanding, then how come most of the QE came in 2008, and yet we've had core inflation below 2% for three years in a row now? Seems like high unemployment and low AD are keeping a lid on your wage-price spirals there, just as theory says it should...

Posted by: Thorstein Veblen | June 14, 2011 at 10:08 PM

Fairly basic economic theory can explain changes in prices for a specific product, service, or commodity, or "good". There are only three possible factors:

1) Supply curve
2) Demand Curve
3) Money supply (in the widest possible measurement)

The first two are market driven forces, a function of human beings making choices in the backdrop of whatever economic system in which they operate (which is now quite global). Exogenous forces such as the government distort the supply or demand curves through policy (such as subsidies, price controls, war, tax code, etc). Natural factors such as whether or climate, or the existence or lack thereof natural resources can affect both curves.

But the ability of a government (via a central bank, typically) to expand or contract the money supply affects prices in a predictable way, holding all other things equal. Remember that simple phrase?

Changes in prices of goods as a result of supply and demand is NOT inflation. They are simply...changes in prices...which is a normal part of a market economy.

Indeed, over time, absent monetary inflation, REAL prices of goods tend to gently decline, as a result of technology. And this gradual decline in prices is how we improve our standard of living over time. It is INCREDIBLE that this basic economic fact is now lost.

The reason there is a source of confusion is how "inflation" is measured. The central bank specifically wants us to think of it in terms of changes in prices. But this is misleading. the proper meaure of inflation would be the increase in price aboe the level where it otherwise would be...were we not to have monetary expansion.

We can have 0% change in the CPI...and still have inflation. Take housing: if we had not had the massive monetary expansion in the last two years, housing prices would have DECLINED much more and much more rapidly. As such, prices are INFLATED...they are being propped up. This is every bit as inflationary as prices increasing as a function of monetary expansion.

The Fed has blurred the line among supply, demand, and monetary expansion...and how much eaach of these affect prices. They don't WANT market participants to be able to isolate the effect that monetary expansion has on prices. In that way, the government can inflate, as we don't easily see just how much dilution of the dollar we are experiencing. Notice the persistent talk about how declining prices are synomomous with DEFLATION, and how this is supposedly bad. A free market will produce naturally declining prices, i.e. a greater standard of living via greater purchasing power. And this is regarded as negative?

Or...we allow an inflation bubble to pop, and the artificial prices brought about by monetary inflation return to where they should be...and this is negative?

It is only negative to the government itself, or to those participants that benefitted from the inflation in the first place. The rest of us are gradually payings its price...through a stealth (and at times not so stealth) decline in the purchasing power of our currency.

Posted by: Chris | June 14, 2011 at 11:35 PM


I wrote about this recently. Go to the 6th chart. It tracks the growth of the Fed's balance sheet (QE) and the CRB.

The correlation between the two is 85^2. In my world that is a very tight correlation. It could not be this high by coincidence.

Review the chart and make your own conclusions.

You may respond; Baloney! The CRB is not the CPI! And you would be right.

I say that CPI is a lousy yardstick. Core is even worse in my opinion. But that is what is used to establish monetary policy.

* CPI-W is up 3.5% in the past six months. Inflation is ripping at an annual rate north of 7% by this measure. That's 3+Xs times the rate of "a little below 2%" that Bernanke has promised.

* High quality arable farmland has doubled in price in just the past three years.

Who's gambling with inflation? I think the Fed is.

Link to article with charts:

Posted by: Bruce Krasting | June 15, 2011 at 08:44 PM

Hi Bruce,

I am not sure exactly what should be included when measuring inflation, and I am convinced nobody really knows for sure. There is no perfectly accurate measure of inflation, and all of the points you mention are very true.

But the government measure of inflation is pretty good. I'd say it is one of the best measures we have. I think this for a few reasons, but the most obvious is that we have yields from the bond markets that need to make sense when we compare them to inflation.

If inflation is being undercounted - like you are claiming here and I've seen you claim in other places - the U.S. government will actually make money when it issues bonds.

I go over the math in a post at my place, but I am sure you know it too. It's standard line MBA style thinking on rates. (1 + Treasuries) = (1 + inflation)*(1 + real rate)

I call it the hyperinflation hoax, because if we were seeing high levels of inflation, the best way for the U.S. to reduce its debt to GDP would be to borrow more money. Nonsensical results like this make the argument for any inflation much higher than 3% suspect, IMHO.

The real rate of return or real yield is what matters for the government. If inflation is anything higher than the BLS says it is, then the government is "paying" a hugely negative rate of interest even on the longest bonds. Paying a negative rate is the same as getting paid. If inflation is higher than 4%, the U.S. is making a ton of money just issuing 6 month T-bills at .11

I go after shadow stats a decent amount because he claims that old measures of inflation would show we have 10% plus inflation. But if we have 10% plus inflation, that means the U.S. government is actually making about 10% on its T-Bills, because T-Bill rates are almost zero.

Inflation in energy has horrible consequences - I am not denying that. But I don't blame speculation on the fed. I don't know how you might finance your trading margins, but most professionals use T-Bills, not cash. Forcing people into cash - like the fed is supposedly doing - should actually reduce speculation, because the vehicle most professionals use to fund speculation is not cash, but T-Bills.

Anyway, enjoy your work - and thanks for sharing your thoughts on so many topics!



Posted by: TC | June 16, 2011 at 09:46 AM

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