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Inflation: Short- and Long-term View

By Doug Short, Steven Hansen and John Lounsbury

The Fed justified the current round of quantitative easing “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate”. In effect, the Fed is trying to increase inflation, operating at the macro level. But what does an increase in inflation mean at the micro level — specifically to your household?  How is the household affected by the short-term CPI and what does that reflect on what may lie ahead longer term?

Let’s do some analysis of the Consumer Price Index, the best known measure of inflation. The Bureau of Labor Statistics (BLS) divides all expenditures into eight categories and assigns a relative size to each. The pie chart below illustrates the components of the Consumer Price Index for Urban Consumers, the CPI-U, which we’ll refer to hereafter as the CPI.

The slices are listed in the order used by the BLS in their tables, not the relative size. The first three follow the traditional order of urgency: food, shelter, and clothing. Transportation comes before Medical Care, and Recreation precedes the lumped category of Education and Communication. Other Goods and Services refers to a bizarre grab-bag of odd fellows, including tobacco, cosmetics, financial services, and funeral expenses. For a complete breakdown and relative weights of all the subcategories of the eight categories, see table 3 in the BLS’s monthly Consumer Price Index Detailed Report.

 The Short View

Here is a table showing the annualized change over the past four months for Headline and Core CPI.  Also included are each of the eight components of Headline CPI and a separate entry for Energy, which is a collection of sub-indexes in Housing and Transportation. We can make some inferences about how inflation is impacting our personal expenses depending on our relative exposure to the individual components.

The Trends in Headline and Core CPI

The chart below shows Headline and Core CPI for urban consumers since 2007. Core CPI excludes the two most volatile components, food and energy.

Core CPI has been on the rise but is still below the Fed’s inflation target of 2%. But the more attention-grabbing headline CPI has nearly doubled since January. If we extrapolate the latest rise over the few months, Core CPI would hit the Fed’s target rate by at some point during the third quarter.

And, of course, extrapolating the recent trend in headline CPI for several months puts that metric in the 6% to 10% window well before year end.  However, the volatility of energy prices makes any extrapolation of headline CPI very problematic, as can be seen in the graph above.  

The Long View

The chart below shows the cumulative percent change in price for each of the eight categories since 2000.

Not surprisingly, Medical Care has been the fastest growing category. At the opposite end, Apparel has actually been deflating since 2000. Another unique feature of Apparel is the obvious seasonal volatility of the contour.

Transportation is the other category with high volatility — much more dramatic and irregular than the seasonality of Apparel. Transportation includes a wide range of subcategories. The volatility is largely driven by the Motor Fuel subcategory. For example, the spike in gasoline above $4-a-gallon in 2008 is readily apparent in the chart.

The Ominous Shadow Category of Energy

The BLS does not lump energy costs into an expenditure category, but it does include energy subcategories in Housing in addition to the fuel subcategory in Transportation. Also, energy costs are indirectly reflected in expenditure changes for goods and services across the CPI.

The BLS does track Energy as a separate aggregate index, which in recent years has been assigned a relative importance of 8.553 out of 100. In other words, Uncle Sam calculates inflation on the assumption that energy in one form or another constitutes about 8.55% of total expenditures, about half of which (4.53%) goes to transportation fuels — mostly gasoline. The next chart overlays the highly volatile Energy aggregate on top of the eight expenditure categories. We can immediately see the impact of energy costs on transportation.

The Education Bubble

Last month Conor Friedersdorf had an article in The Atlantic Monthly with the title “Is There an Education Bubble.”  Conor starts that article with the following:

University defenders say an education has value far beyond the difference it makes in your salary – but upper-middle-class Americans tend to overvalue the non-financial benefits of grad school too.
 college grads full.jpg

Peter Thiel says that there is an “asset bubble” in higher education.  As I ponder the rebuttals from critics like Freddie, my instinct is that financial metaphors are obscuring more than they’re clarifying. “Education cannot survive on what I am horrified to find is the generally assumed model, that it exists for the purpose of increasing earning potential,” Freddie writes. “To see an education, college or otherwise, as merely a way to increase the amount of money you make is a terrible corruption.”

A number of others have reported on the problems with education and the funding of higher education, some reported here at GEI.  The next chart will come as no surprise to families footing the bill for college tuition. Here I’ve separately plotted the College Tuition and Fees subcategory of the Education and Communication expenditure category. Note that the steady staircase in this cost matches the annual cost increases in late summer for each academic year.

Core Inflation

Economists and policy makers (e.g., the Federal Reserve) pay close attention to Core Inflation, which is the overall inflation rate excluding Food and Energy. Now this is a somewhat peculiar metric in that one of the exclusions, Energy, is an aggregate that combines specific pieces of two consumption categories: 1) Transportation fuels and 2) Housing fuels, gas, and electricity. The other, Food, is the major part of the Food and Beverage category. I should explain that “beverage” for the BLS means alcoholic beverages. So coffee and Coca Colas are excluded from Core Inflation, but Budweiser and Jack Daniels aren’t.

An even greater problem with the definition of “core” is the analysis by Steven Hansen which shows that, while the Fed lumps Food and Energy together as an exclusion to calculate Core Inflation, the two exclusions have very different correlations to the rest of the CPI (the “core”).  The following graph shows that the Food has a close correlation with “core”, while Energy does not:

There is a clear implication that ignoring Food Inflation in defining Core Inflation is a significant misrepresentation of reality.

The next chart shows us the annualized rate of change (solid lines) and the cumulative change (dotted lines) in CPI and Core CPI since 2000.

Consumers, especially those who’ve managed expenses over several years, are most closely attuned to the top line.

Inflation and Your Household

The universal response is to moan over price increases and take delight when prices are cheaper. But in reality, households vary dramatically in the impact that inflation has upon them. When gasoline prices skyrocket, a two-earner suburban family with long car commutes suffers far more than the metro family with short subway commutes. And remember, Uncle Sam excludes energy costs from Core Inflation.

Households with high medical costs are significantly more vulnerable than comparable households with low expenses in this category.

The BLS weights College Tuition and Fees at 1.493% of the total expenditures. But for households with college-bound children, the relentless growth of tuition and fees can cripple budgets. Often those costs get bundled into loans that saddle degree recipients with exorbitant debt burdens. Consider the following numbers from the CollegeBoard.com website:

  • Public four-year colleges charge, on average, $7,605 per year in tuition and fees for in-state students. The average surcharge for full-time out-of-state students at these institutions is $11,990.
  • Private nonprofit four-year colleges charge, on average, $27,293 per year in tuition and fees.

Of course, Mr. Bernanke would point out that, with a healthy dose of Core Inflation (extended of course to wages), those debt-burdened college grads will pay down the loans with inflated dollars.

Which brings us back to the Fed’s efforts to increase the level of Core Inflation. At the macro level, Mr. Bernanke and his Federal Reserve team can doubtless make a theoretical argument for playing puppet master with inflation. But will their efforts — ZIRP and Quantitative Easing — achieve the desired goal?

The one thing we can be certain about is this: An increase in inflation will have a painful effect on lower income households, those on fixed incomes, those with higher ratios of transportation costs, and any household whose discretionary spending is more dream than reality.  Education cost inflation and out-sized medical costs growth will reduce living standards for lower income families and many in the so-called “middle class.”  And persistent higher Food Inflation will almost certainly produce higher Core Inflation.

Related Articles

CPI:  Consumer Prices Up 3.2%  by Steven Hansen and Doug Short

Beware:  Core CPI Follows Food Inflation  by Steven Hansen

Bad Education  by Malcolm Harris 

Is There an Education Bubble?  by Conor Friedersdorf (in The Atlantic

A Few More Things About College  by Freddie (at L’Hote)

More Than 40% of Student Loans have Payment Problems  GEI News

College Training for Unemployment  by Mike Konczal

Snake Oil, Paul Krugman, Student Loans & Consumer Credit  by Steven Hansen

U.S. Problems are Institutional  by John Lounsbury

Underneath the Happy Talk, Is This As Bad as the Great Depression?  by Washington’s Blog

Decline – We Are Doing it to Ourselves  by John Lounsbury

A View of a New America – You Won’t Like It by Admin

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2 Responses to Inflation: Short- and Long-term View

  1. Your lead-in was: “The Fed justified the current round of quantitative easing “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate”. In effect, the Fed is trying to increase inflation, operating at the macro level.”

    In my view, the Fed’s objective was to drive down the value of the dollar on world markets in hopes of bringing manufacturing jobs back to the US. And that is why foreign leaders were so upset with this action. Of course, as a by-product, a weaker dollar will mean US consumers will have to pay more for goods with an import content). But it was certainly not the Fed’s intent to cause a domestic inflation….

    • Elliott – - -

      I believe you have a clearer statement of the end objective. A stated Obama policy has been, from the beginning of his term, to increase exports. Increasing macro-level of inflation is the same as competitive (vs. other currencies) devaluing the dollar. Such a strategy can produce an improvement in the export/import ratio, but some have claimed that there is a limit to how far that can go. Those people maintain that a sovereign currency that serves as the world’s reserve currency is forced to suffer a balance of payments deficit as part of its role. Others have called the attempts at competitive devaluation a “race to the bottom.”

      However, looking at the totality of your comment, wouldn’t you agree that the Fed has a stated objective of increasing core CPI to 2%? That would be the justification for our statement.