Thursday, August 14, 2008

With Core Inflation At 2.5%, Inflation's Not a Worry

According to Brian Wesbury and Bob Stein, "Inflation is the leading menace to the US economy."

Although I usually agree them, I don't see inflation as much of a menace right now. The core CPI inflation on an annual basis was 2.5% in July, barely above the 10-year average of 2.21%, below the levels close to 3% between mid-2006 to early 2007, and way below the 4.58% average since 1970 (see graph above).

In my opinion, unless and until the core CPI inflation starts to rise, inflation ain't a big problem. For example, inflation WAS a huge problem in the 1970s and early 1980s, but it was when CORE CPI INFLATION was rising by double-digits, not just oil, energy and food prices. By definition, inflation is a phenomena when ALL prices, in general and on average, are rising, NOT just food and energy. With core inflation so low and stable, I don't see how inflation can be a menace. And with oil prices plummeting and the dollar soaring, look for August inflation, both overall and core, to moderate.


At 8/14/2008 1:43 PM, Anonymous Anonymous said...

I’m sure there is a logical reason; however, I don’t see the value of discussing inflation without including food and fuel. What’s the useful purpose? It isn’t what we experience in the real world. It’s exactly like discussing gross pay instead of net pay. In one case I am not going to get the money, and in the other I am going to spend the money. Omitting food and fuel in the inflation calculation appears more a case of deception than anything else to me. I can’t use this information in any decision-making process, so why do I need to know it?

At 8/14/2008 1:45 PM, Anonymous Anonymous said...

I disagree. Core inflation for July was 3.6% on an annualized basis, not 2.5%. For the *year* ending in July, it was 2.5%. This indicates that core inflation heated up in July.

At 8/14/2008 1:49 PM, Anonymous Anonymous said...


While it may make sense to include food and energy when you are trying to figure what is happening to the cost of living, it doesn't make sense to include them if you are trying to figure out what is happening to the economy. Because food and energy have volatile prices, inflation including these factors can give you a misleading view of the overall economy.

At 8/14/2008 1:54 PM, Anonymous Anonymous said...

I agree that problematic inflation occurs when the prices of all goods, rather than just food and energy, are rising. However, the annual number, 2.5%, is old news - on a monthly basis and rounded to 2 decimal places, core has rose more in July than it has since 2001, 0.33%.

Sure, headline inflation will post a strong deceleration (even contraction) next month due to falling energy prices (gas, oil, electricity); however, it is unclear what will happen to core. Certainly, with non-petroleum import prices rising at rates not seen since....well, ever (8% in July), that has to count for something.

Despite an economic slump and contracting labor force, firms have started passing through higher energy prices (which takes a while) to a wider basket of goods, both domestically and internationally.
If I were Bernanke, I would be worried.

At 8/14/2008 1:54 PM, Anonymous Anonymous said...

Thanks, Mark, that makes sense. I just want to make sure that everything is in the open. We would have to make sure that the food and fuel prices are likewise omitted if their inclusion would drive down the inflation rate. I'm not sure that would be the case.

At 8/14/2008 3:46 PM, Blogger the buggy professor said...

1) One of the problems in figuring out what price rises concern average households is the elasticity of demand for the products covered by the CPI.

2) The demand curve for oil-energy is highly inelastic, at any rate at the start of any major price rise.

In other words, the D-curve is nearly vertical. A sharp rise in oil prices will not reduce the quantity of overall demand economy very much: people can't all quickly trade-in gas-guzzling vehicles, can't all quickly form car pools, can't all start taking public transportation (whose prices will rise too), and can't swiftly stop heating their homes if using oil for that purpose.

The upshot?

When faced with a sharp rise in oil, such as we have experienced the last several months (until three weeks ago roughly), people find it a big annoyance and start worrying about how to make ends meet.

And of course businesses that have to transport their wares --- never mind produce goods with petroleum products --- can't easily reduce their usage or substitute away quickly either.

For the core CPI to ignore this problem does seem to be unrealistic --- just as Walt argues.

3) Food is different.

Obviously we can't live without it, but there is lots of room for immediate substitution --- say, between expensive rib-eye steaks and cheaper hamburger or chicken. The average household may not like to make these changes, but substitution will quickly occur. That makes the D-curve for food much more elastic in even the short-run.

In that case, it seems, core CPI could ignore the ups and downs in food in "sound" ways that it shouldn't do with oil-energy and its various products.

4) Over time, of course, even the highly vertical (inelastic) D-curve for oil aand otherenergy products will grow more elastic, all things being equal. People do start substituting away from gas-guzzlers, use public transportation, car-pool, walk, or ride a bicycle where feasible.

In the mid- to long-term --- say, 10-25 years --- if the price of oil remains high, alternative energy sources will be tapped . . . including new high-tech ones, most likely based on electricity that draws on a variety of fuel-imputs, including solar, wind, nuclear, hydrogen, natural gas, and maybe environmentally safe coal.

5) Of course, not "all things being equal" may hold.

If China and India and a few other rapidly developing large countries continue to import more and more oil, then the overall global D-curve for oil may rise (shift upward and outward) and nullify the substitution effects that make it more elastic in both advanced and developing economies. It all depends.

Since it’s likely they will continue to grow strongly in the next decade or two, we should likely prepare for overall global demand for oil to rise steadily, outpacing any increases in oil supplies and substitution and conservation effects that would make the D-curve more elastic.

6) No need to despair though --- just the contrary.

Our biggest hope, you see, is to start tapping alternative energy sources --- especially non-oil ones that are also more benign for the environment. Only such high-tech innovations --- which should be a huge production-windfall for a technological leader like the US (rather than being seen as a cost-burden in the long-run)--- will solve our problems.

And, let us hope, reduce the military-security-foreign policy spillovers that reliance on Central Asian, Russian, and Middle East (and Venezuelan) oil now entail, while making these oil-rich gangster states less assertive and militant in their foreign policies.

7) For the rest, to get back to the CPI and for that matter the GDP price-deflator (which is far different), it's something that has been argued about for decades by specialists and others --- and won't be settled by what I or others say here, however strongly we feel about it.

Not least, you see, it is a politicized issue, what with the indexing of social security and certain wage-contracts to the CPI. The Boskin committee --- which recommended the use by the BEA of chain-linked measures and substitution and quality-estimates --- admitted back in the mid-1990s that there was a fairly large range of "over-estimation" of the CPI in previous decades.

The same could be said these days, as Walt and others suggest (and I agree with about energy prices but not food), of "under-estimation."


Politically, too, there’s one more matter to single out: how voters will judge the overall condition of the economy as the November elections approach, always a major influence shaping the votes of independent swing voters. As Obama's and McCain's own flip-flops show on off-shore oil production or tapping our security-reserve, the presidential candidates and party heads are fully aware of voter sentiments about both price-trends and growth-trends.


Michael Gordon, AKA, the buggy professor

At 8/14/2008 5:49 PM, Anonymous Anonymous said...

"By definition, inflation is a phenomena when ALL prices... are rising..."

I thought inflation occurs when shortages of goods are paired with plenty of money, which leads to increases in prices. High prices without shortages of goods is not inflation. Shortages of goods paired with lack of money does not cause inflation because prices cannot be bid up.

We have not had significant inflation in years, which is why I cannot understand the high interest rates set by the Federal Reserve Board. These high rates have added about 40% to the price of gasoline and to many foreign imports. The high rates (~1% higher than Europe and over 2% higher than Japan) also hurt the home building and home mortgage sectors. Fear of inflation is damaging our economy.

At 8/14/2008 7:00 PM, Blogger the buggy professor said...

The following two links might help you grasp what's at stake in the estimates of inflation --- especially the CPI.

1) A very useful graphic that breaks down the CIP products by percentage of household expenditures (on an average) from the NY Times, published in May of this year:

2) A very good macroeconomist, Robert Gordon of Northwestern --- who was on the Boskin Commission that found the CPI had been over-estimating the annual rate of inflation by 1.1% annually in previous decades --- looks at how the Bureau of Labor Statistics has grappled with the Commission's recommendations: consider quality changes, look at substitution effects, take into account discount chains (Walmart has been charging about 28% lower for average grocery puchases than independents), and --- a technical issue to boot --- use a chain-weighted path-dependent way of tracing prices.

Gordon thinks the BLS --- which creates two kinds of CPI variants --- has done a pretty good job with the recommendations. It turns out, though --- as he looks at studies over the previous 10-12 years since the Boskin Commission reported --- that it may have UNDER-estimated the degree of substitution in high-cost goods.


None of this will settle the dispute unfolding here in this thread, never mind among specialists on price-levels and statistical tracking and the weighting of various items in the CPI . . . never mind the economic technical issues involved (some quality deteriorates over time --- think of robotic telephone systems and waiting times for service-help in, say, computers and its accessories ) and the no less weighty political spillovers.


Remember, these technical issues are hard to handle.

Take quality improvements or, alternatively, deterioration --- the one I just mentioned.

Sure, service-calls are a headache for almost all of us. On the other hand, pc's and accessories are generally far more reliable these days than when they were first introduced in the 1980s and 1990s. How does a statistician at the BLS balance these two considerations in looking at overall quality trends?


Note finally that the European Central Bank uses a different variant of our CPI, and --- believe it or not --- our Federal Reserve uses a different kind of inflation measure than the government's, using a Personal Consumption Expenditures that excludes food and energy and hence is similar to the core inflation rate of the CPI.



Michael Gordon, AKA, the buggy professor

At 8/15/2008 12:32 AM, Anonymous Anonymous said...

Your chart says that the core inflation rate has increased by about 50% since 2004. What exactly is there to brag about (as you are wont to do)?

At 8/15/2008 10:04 AM, Anonymous Anonymous said...

buggy professor,

Wouldn’t the loss of quality from substituting hamburger for steak have to be quantified and taken into account somewhere in the inflation rate? Additionally, the volatility of food and fuel would seem to assume it’s cyclical. Isn't that the definition of volatility? What if $4 gas is here to stay?

Sure, we will find a way to use less gas by finding substitutes and altering our lifestyles, but we will be paying for that technology, too. And you can be sure that will not be cheap or the choices that we prefer. If I ride my motorcycle instead of driving my truck to work, how will the inconvenience of getting soaked in a rain or blasted by hail be quantified? These substitutes are not even trades.

As long as inflation is measured by ALL goods as stated by Wesbury and Stein, and I continue to have to pay for ALL goods, I think I will take any mention of core inflation with a grain of salt—or salt substitute, if the price of salt has increased too much.

At 8/15/2008 2:24 PM, Blogger the buggy professor said...


You're voicing, I believe, justified concerns about the use of the core CPI that reflect most households in the US --- at least on energy.

And yet, technically, we need to have some guide for the Federal Reserve heads to decide if they should start adjusting interest rates --- short-term ones anyway (the only ones the Fed can directly influence) --- because overall inflationary pressures have been set loose in the US economy.

But note: the price of oil that soared from about $110 to about $150 between May and way into July. Since then, there has been a similar magnitude of drop back to the original level three months ago or so. That's too much volatility from the Fed's viewpoint when it comes to judging whether it should, say, start raising interest rates . . . with all the consequences that would follow as the US economy seeks to stay out of recession.


This argument can be taken a step further.

If, to put it bluntly, anyone is still worrying about the price of oil dropping too far, too fast (say, below $3.00 a gallon for gas) --- and in the process, then, offset the substitution and conservation efforts of lots of our public, who are betting on a long-term hike in gas and oil-based goods or services --- that's a good argument for setting a floor price.

It will send the kind of signal, that floor price, which will encourage most of alternative energy R&D and the efforts of auto companies like Gm and other business firms to deal with the long-term consequences of high-priced oil. And, simultaneously, it should also send a similar signal to households to think in long-term terms as well.

Then, too, in my opinion --- which is not that of a libertarian, but someone who sees all our energy systems (including oil, coal, natural gas, nuclear, hydro-electric, and now ethanol) heavily subsidized --- we could hasten the shift away from oil-based energy to electrification that could draw on these sources, but also innovative, high-tech sources in the near future . . . say, the next four or five years, with a lengthier transition that will probably extend for about a decade or two beyond that.


Oh, lest we forget: there's the big danger that further reliance on imported oil by us and our allies (Europe and Japan) has been fueling aggressive, militant behavior by the gangster-dictators of Iran, Russia, and the Saudi double-dealing anti-Jewish, anti-Christian, misogynist Wahhabi zealots . . . not to forget, on a different level, Chavez in Venezuela. All these oil-fueled gangster states have cost us heavily in extravagant military spending and, at times, brutal warfare as in the oil-drenched Saddamite and post-Saddam Iraq. Without its oil and gas industries, Putin’s Russia would be an economic basket-case and unlikely in a position to fund a well-prepared invasion of Georgia.

What follows?

Just this. Economists need to start dealing with these military and foreign policy vulnerabilities of our dependence, along with that of our major allies, on foreign oil and the implications for not just global stability but the fate of globalizing trade and investment as the American people and others in the West begin to show clear signs (with some differences across countries) of rebelling against such globalization.

Otherwise they will go on carrying out cost-benefit analyses that exist in a dream-world of global stability, harmony, and mutually beneficial interdependence, to the advantage of one and all . . . an illusion that is a good century or more old.

The most famous book of that genre, observe carefully, was published by a British liberal, Norman Angell, on the eve of WWI. Called the "Great Illusion," it argued that Germany, Britain, and the other subsequent European belligerent states were too heavily interdependent in trade and investments to risk the huge costs of war with one another. That was in 1913. WWI broke out the next year.


Over the next 3 decades, until 1945, te fate of Europe (and the rest of us eventually) didn’t seem to bear out these assumptions of economic progress, international League of Nations cooperation, mutual interdependence, and ever greater costs of major wars compared to the potential gains for winners. And the history of the cold war, between 1946 and 1990, didn’t seem to match liberal illusions either.

Is the same great illusion at work today?

Fortunately, there is one big difference: the huge dangers of nuclear war, and hence mutual nuclear deterrence, between stable, nuclear-armed or –protected states not led by fanatical ideological zealots.

A query here: is Iran representative of such a stable, non-fanatical state? Maybe an outright missile-attack with nuclear weapons on Israel or our military forces in the Middle East would be suicidal . . . too great a risk even for the Shiite zealots in control of Iran.

But what if these Shi-ite zealots were tp decide to let hezbollah or Hamas suicde-bombers plant dirty nuclear bombs in Israeli cities? Or, possibly, in our own? Who can be sure?

What would be the Israeli or American response?


Michael Gordon, AKA the buggy professor

At 8/15/2008 3:58 PM, Anonymous Anonymous said...

buggy professor,

I don't doubt that you have legitimate world concerns, but I am going to scale back the scope of the discussion to the title of the original post: "With Core Inflation At 2.5%, Inflation's Not a Worry"

My point was that core inflation does not reflect how the average person spends his or her money, so inflation, which includes ALL purchases, IS a worry. Just ask someone who has five kids to feed and drives 60 miles to work one-way everyday.

I have learned and grown through the discussion by understanding that policy makers, such as the Fed, need the more stable core inflation data to make adjustments to the economy. As is often the case, how one interprets different measurements depends on their purpose. Core inflation, however, is an esoteric concern.

Here’s an apt analogy for me to close with: Some people interested in the weather might be interested in the average temperature in the United States. I would find that information about as useful as I would find core inflation data. I want to know the weather where I am at and where I may travel to. If I am freezing my ass off in Alaska at 10-degrees-below-zero, it does me very little good to know the average temperature in the all 50 states is 48.5 degrees: Does it?

At 10/08/2008 11:48 AM, Anonymous Anonymous said...

It seems to me that it would be a simple solution to take the volatility out of food and fuel by using a 3 or 6 month moving average; thus allowing the inclusion of these two critical components in the core inflation rate. It doesn't seem like it would take much to figure this out, which makes me question why it is not being done.


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