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Inflation Insights: A Look the Latest Numbers
Inflation is at the top of everyone’s mind.
Until you live with inflation, you don’t really understand it and you definitely don’t fully appreciate how damaging it is. This year is going to be an ugly awakening for a lot of people in the US and around the world as we deal with actual inflation for the first time in 40 years.
The Latest Reports
Last week there were three important inflation reports in the USA. None of them were good. I put links to all of them at the bottom of this report in case anyone is interested.
First was the Consumer Price Index (CPI). Think of the CPI as the average of all the prices of the things consumers actually buy. The CPI for April rose 8.3% compared to last year. That is the main “inflation” number everyone is discussing.
Second was the Producer Price Index (PPI). Think of the PPI as the average of all the prices producers/businesses buy stuff at. That is, it’s sort of a measure of the costs businesses pay for all the inputs they need to make the goods they sell to consumers. The PPI went up in April by 11% compared to last year.
Finally, was the Import Price Index. That is an average of all the prices of imports to the United States economy. And, if you think about it for a moment, you’ll realize that it’s also sort of a producer price index since most of the imports to the economy are inputs to businesses. Even if it’s a shirt or something that consumers want, it’s still imported by a clothing company or Amazon or Walmart or whatever and then sold to consumers. The Import Price Index rose 12% compared to last year.
In a nutshell, the PPI and Import Price Index tell us that costs for businesses are still rising by 11-12% year over year. That eventually gets passed on in part or in whole to consumers. If businesses pay 11-12% more for things, they will eventually need to charge more for the goods they sell if they expect to stay in business. The PPI is a “leading indicator” meaning it rises first, then a few months later that gets transmitted to final goods prices (i.e., the CPI), although not necessarily one-for-one. So that means 8.3% probably won’t drop too much in the coming months. That’s the bad news.
The good news is that these are all a little lower than last month. Last month the numbers were that the CPI rose 8.5%, the PPI rose 11.5% and the Import Price Index rose 13%.
Behind the Numbers and Some Interpretation
When inflation first really took off this year, the Federal Reserve – whose job it is to control inflation – initially kept making a distinction between “core CPI” and “headline CPI”. The 8.3% number is “headline CPI” and it includes everything, including energy and food costs.
Energy costs are very volatile and can swing a lot in any given month. So can food prices. And, while gas prices might rise in summer or a crop might be good or bad one year, we don’t really see that as a broad indicator of inflation. As a result, the Federal Reserve likes to look at the CPI without energy and food included.
That may seem odd, but in the Fed’s defense, they are watching for “actual inflation”. Whenever any price rises we consumers cry about high prices and might even call it inflation. But the inflation the Fed and most economists watch for is a general and sustained rise in “all” prices over a longer period of time. I like to think of it as “substantial and sustained inflation”.
That substantial and sustained inflation is the result of too much money being pumped into the economy, all else equal. As a result, that’s the part the Fed can actually have some chance to control since the Fed is responsible for monetary policy, particularly the amount of money, and has a mandate to maintain “price stability” in the US economy.
When inflation first really started to rise, the Fed often defensively pointed out that “core inflation” was what they watch. They target that to be around 2.5% and, while headline inflation rose, they claimed not to be overly concerned because core inflation was still just a little above target and that was okay.
The big change with the latest numbers is that “core inflation” hit 6.2% compared to last year. That means, excluding energy and food inflation, general inflation has now taken root so to speak across the economy.
And, if you want a real head scratcher, energy prices actually fell some in the latest inflation reports. March saw a big spike in energy prices with the war in Ukraine – which obviously isn’t over yet – and so energy prices actually came down a bit since March. Gas prices fell 6% between March and April although I’ll admit I don’t feel that at the pump.
This all tells me that the Fed should now really worry about inflation. The concern is not so much that it will continue to rise rapidly – although that’s still possible – but that now it’s really spread everywhere and will be hard to get rid of. As I’ve mentioned before, it is also concerning that now inflation has been high for a while.
The longer it’s around, the more people build it into their plans, salary negotiations, and so on. When that happens it is because everyone expects inflation to continue. And those inflation expectations worry the Fed a lot because every month the Fed doesn’t act boldly is another month people don’t believe the Fed will get us back to 2.5% inflation any time soon. And a Fed without credibility is unable to control inflation.
For now, I see that inflation is with us for a while. With the costs of inputs for businesses continuing to rise at 10+ percent, there’s just no way consumer prices drop a lot. And as long as the war in Ukraine continues, the Europeans will move off of Russian oil. As they do that, they’ll start buying from the rest of the market and drive up the demand for oil that we also buy. That’ll keep pressure on oil and hence gas prices for some time. And those prices affect everything because they affect transportation costs (trucks, planes, Amazon delivery, UPS, and so on).
Measurement Issues: “Base Effects”
There were some mentions of “base effects” in the news already and I think that we’ll hear more in the coming months so I’ll explain here. To start, the “base” is just the benchmark or base case against which you compare something. So, saying prices rose 8.3% in April compared to last year makes last year the “base”. In normal times that’s not much of an issue. But we definitely aren’t living in normal times.
Just before Covid, in January 2020, annual inflation was about 2.5%. Covid hit and in May 2020 inflation fell to .3%. Sorry to get technical here, but that means that average prices in May 2020 were .3% higher than they were in May 2019. That’s not a lot. It’s basically zero. If something cost $1 in May 2019, it still cost $1.00 in May 2020 (technically $1.003 but we don’t have anything less than pennies, so it would just be $1.00 on the shelf).
The next year in May 2021, however, inflation was 5% (technically 4.94%). It was hard to know if that was really “inflation” of 5% or just prices getting back to normal. Notice that if they had been rising 2.5% a year (in a world without Covid), then over those two years, they would have risen about 2.5% a year which is about 5% total. To see that, if something cost $1.00 in 2019 and then $1.05 in 2021, it rose 5% since 2019. If it had gone up normally at 2.5% a year, then in 2019 it was $1.00, then 2020, $1.025 (for the 2.5% inflation) and then another 2.5% in 2021 to bring it to $1.051. So it’s hard to tell if $1.05 in 2021 is “back to normal” or reflecting a surge in inflation.
This is why they weren’t sure if higher prices last summer were transitory or not. If they were transitory then we might still have seen about 5% inflation. That would have returned prices to normal and then inflation would have continued another 2.5% this year (i.e., at normal or target inflation).
Instead, annual inflation continued to rise each month throughout the summer of 2021. And this brings us to today.
Last year inflation was about 5% for the year. The fact that prices rose another 8% means a lot. That $1.00 candy bar in 2019, for example, now costs about $1.13. If we had returned to normal it would only be about $1.08 (2.5% more than $1.05, to keep the example).
So the question they have been watching, but were trying not to draw much attention to is this. If we keep getting 8% on top of last year’s 5%, then we have a real inflation problem. As each month passes through the summer, we’re comparing inflation this year to the base last year which was already up. The hope was that inflation would slow a lot this year, suggesting that last year’s 5% was a return to normal.
Each month that passes this year with inflation at anything above 2.5% (i.e., normal) tells us that last year’s inflation wasn’t transitory. It was instead the beginning of some serious inflation.
So each month’s data release worries the Fed more and more. And now the Fed’s preferred measurement of inflation, excluding energy and food prices, is also 6.5%. So they are worried. Inflation is here. It has spread. It has taken root. It will be very hard to get it down to 2.5% again.
A Final Note
I’m sorry, I should have ended with the last paragraph, but one final comment, just to clarify things. When inflation stops, prices don’t fall back down to where they were. For them to actually fall back down would be deflation.
I only mention this because I often hear commentators say “well the Fed needs to get inflation under control and get prices back down to normal levels”. Technically that’s wrong. If inflation were zero, all the prices would stay where they are today.
Sorry to bear bad news but the higher prices are here to stay. Our hope at this point is only to keep them from rising much more going forward.
Consumer Price Index: https://www.bls.gov/news.release/cpi.nr0.htm
Producer Price Index: https://www.bls.gov/news.release/ppi.nr0.htm
Import Price Index: https://www.bls.gov/news.release/ximpim.nr0.htm
 This is actually accurate. It’s just a “weighted average” where the weights are based on what they call the typical basket of goods consumers buy and they have a complicated way to calculate it so that it accounts for things like new product and how consumers respond to different prices rising. But in the end, it’s just a well-calculated average.