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Analyst Blog

Dirk van Dijk, CFA

Inflation Low (and Will Stay That Way)


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Consumer prices fell by 0.1% in October. The Consumer Price Index (CPI) rose by 0.3% in September, and by 0.4% in August. The trend is thus very much in the right direction. On a year-over-year basis it is running a bit hot at 3.5%, but that is down from being up 3.9% year over year last month. The consensus expectation was that headline inflation would be unchanged for the month.

Energy Prices

Looking a little bit deeper, the decrease in headline inflation is mostly with energy. Energy prices fell 2.0% in October, but that reversed a 2.0% increase in September, which came on top of a 1.2% rise in August. Overall energy prices are up 14.2% year over year.

Actually the movement is even narrower than that, as energy commodities such as gasoline and heating oil were down 2.9%, more than reversing a rise of 2.7% September, on top of a 1.6% jump in August. Year over year energy commodity prices are up 23.4%.

While the price of oil fell in late September and early October, recently it has rebounded, and WTI is once again flirting with the $100 a barrel level. Mostly, though, that is just closing the huge spread that had opened up between WTI and Brent, and Brent is the real benchmark.

Energy service prices, like electricity and piped gas service, have been much better contained. They fell 0.4% in October, after a rise of 0.7% in September which came after three straight months of being up 0.4%. However, year over year energy services prices are up just 1.7%. In other words, the pain has been at the pump, not in the plug.

Oil prices have been very volatile. The price of gasoline seems to be tracking the price of Brent, the world benchmark, much more than the price of WTI, which is the historic U.S. benchmark. WTI has declined significantly in the August and September market turmoil, but Brent much less so, and it has not increased the way that WTI has in recent weeks. Still, it seems likely that we will see a rise in energy commodity prices in November.

Food Prices

Food prices have been a bit more problematic than overall inflation, but nothing like energy commodities. The news there was also pretty good this month, with prices up just 0.1%. They rose 0.4% in September, down from a rise of 0.5% in August.

Year over year, food prices are up 4.7%. However, year over year food prices at the grocery store are rising faster than restaurant prices, and those are a lot less discretionary than going out to eat. Grocery store inflation was also 0.1% this month, but that comes after three straight months where they rose 0.6%.

Year over year “food at home” inflation is 6.2%. That is hardly Zimbabwe, but it is higher than the rest of the economy. That sort of pace is taking a serious bite out of consumers' wallets, especially lower income consumers who tend to spend a much bigger share of their income on food.  

Many of the key agricultural futures have doubled over the last year or so. So far they have had relatively little impact on consumers shopping at Kroger’s ([url=]KR[/url]). The actual cost of raw wheat is a very small fraction of the actual cost of a loaf of bread, so one would not want to exaggerate the likely impact of higher prices in the commodity pits on prices at the checkout counter. That is not as true elsewhere in the world, and rising food prices have already started to cause unrest in some countries.

Core Inflation Up 0.1%

Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up just 0.1%, the same pace as in both September and August, and matching the consensus expectations. Year over year, core prices are up 2.1%.

The rise in core prices is worth watching -- and is a reason for concern, but not panic. While everyone consumes food and energy, their prices tend to be extremely volatile, and can be influenced by external events. As such, the Fed tends to focus more on core prices when setting monetary policy.

The graph below tracks the long-term history of the CPI (year-over-year change) on both a headline and a core basis. Note that core CPI is coming off a near-all-time low for the period on the graph (and I cut out the really high inflation 1970’s so you could get a better sense of the more recent movements). The year-over-year change in core CPI record low level of 0.6% was set in October 2010, and records go back to 1957.

Market Not Fearing Inflation

The market seems to think that inflation is not going to be a serious problem for a long time. If it were worried about it, it would not be willing to lend to the government for 10 years at a rate of about 2.0%.

The best measure of the market's expectations of longer-term inflation is the spread between regular T-notes and the inflation-protected TIPS of the same maturity. Here is the history of both since the inception of TIPS.

The relatively illiquid market for TIPS (only relative to the market for regular T-notes, which has as much liquidity as the Pacific Ocean) caused a bit of an anomaly during the financial meltdown, but other than that the difference between the two, the implied forecast for inflation has been quite stable in recent years and is currently narrower than it was before the start of the Great Recession.

The rise in core inflation to over 2.1% year over year makes life a bit more difficult for the Fed. It has a dual mandate to both control inflation and to promote full employment. It is still doing a good job on the inflation front. The pace of the last three months ago works out to be just 1.2% annualized.

At 9.0%, the unemployment situation is anything but satisfactory. In the graph below, look at the level of inflation relative to recent history relative to the level of unemployment (green). The core rate is still very low relative to where it has been, and even the headline rate is well within the bounds of what we have been living with ever since the back of very high inflation was broken by Volcker in the early 1980’s. Since 1960, year-over-year core inflation has been above the current level in 76.4% of all months, but unemployment has been higher than current levels in just 7.8% of all months.

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