Inflation: If only we could “Ex” food and energy – Published in the SB News Press in May of 2011

Last week I wrote about inflation, deflation and stagflation, all of which can be serious challenges to an economy.  In this week’s column, I will address the components of inflation, and discuss how inflation and its component parts affect the everyday citizen.

The measurement of inflation, like so many economic indicators we read about and hear about on the news, is complex.  Often, the way these indicators are calculated becomes so convoluted that they no longer relate to the average person’s daily life.  Additionally, there are adjustments that are made to some indicators, which are thought to be necessary to “smooth” the data over time (to make it more meaningful as a series of numbers).  The reasoning for these adjustments only makes sense in the context of evaluating trends for the broad economy over time, and does not help the average person understand the day-to-day impact that the changes to these indicators has on their lives.

The Consumer Price Index (CPI) is the most recognized and most often discussed indicator for consumer-level inflation, while the Producer Price Index (PPI) is the indicator most often used for producer-level inflation.  The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.  This market basket of goods and services is kept constant so that the prices of that basket can be compared over time to track price changes and thereby track inflation (or deflation).  The calculation of inflation indicators, as with most economic indicators, has evolved over time, as the economy has become more developed and complex.  The tough part for the average person is that the basket of goods may or may not represent what the average person buys on a monthly basis.

The government’s Bureau of Labor Statistics, which is responsible for calculating the CPI, releases information on inflation each month.  Their most recent report for March CPI was released on April 15th,and showed that consumer-level inflation rose 0.5% in March.  This CPI reading was for “all urban consumers,” and was calculated on a seasonally-adjusted basis.  “All urban consumers” means that the government is measuring the average inflation on the consumer level within cities as opposed to rural consumers (who have somewhat differing spending habits).

The government adjusts their readings based on the time of year to smooth the data, or, in other words, to take out of the calculation the impact of the season of the year within which the inflation occurred.  Various things happen at different times during the year that speed up or slow down the economy, so to try and get a more accurate reading of the true level of inflation, the government makes adjustments to offset these seasonality factors.
The “All Items Index” increased 2.7 percent over the past 12 months, before seasonal adjustment.  “All items” simply means that the entire basket of good is included in the calculation.  There are other specialized calculations that remove some items to attempt to get more usable data (more on this below). 

Gasoline and food prices continued to rise in March and together accounted for almost three quarters of the seasonally adjusted all items increase in March.  The gasoline index (a specialized inflation measure) posted its ninth consecutive increase and has now risen 14.4 percent over the last three months. The household energy index  rose as well, with advances in the fuel oil and electricity indexes more than offsetting a decline in the index for natural gas. The food at home index continued to accelerate in March, rising 1.1 percent as all six major grocery store food groups increased.

These specialized inflation indexes remove some of the goods in the all items basket to focus on one area of inflation.  These indexes are useful tools for economists who are trying to get a better sense of the component parts of inflation—what specific areas of the economy are increasing or decreasing in price.  These individual price shifts can help us to understand where supply and/or demand is increasing or decreasing, from month to month, or year to year.

The index for all items less food and energy rose 0.1 percent in March, a smaller increase than in the previous two months.  The CPI index, ex food and energy is referred to as “core” inflation and is the measure most often cited as the best measure of “real” inflation over time.  Food and energy have been volatile historically, and tend to fluctuate more than other commodities.  By removing them from the CPI calculation, economists get a better sense of the longer-term trend in inflation (without the month-to-month interference of dramatic changes in food and energy prices). 

As stated above, in so many areas of economics and finance, the information made available to the public, although better than nothing, is really intended for economists and financial analysts to measure broad-based economic trends, to understand the state of the financial markets, the money supply, imports and exports, and the like.  This information is really not formatted for the average citizen to use, to help them understand how the changes we are experiencing in the economy are going to affect their daily lives. 

As an example, core CPI—again removing food and energy from the calculation—might help economists understand the long-term trend in inflation, but it doesn’t do much for those of us who have to buy food and energy on a regular basis.  We care about monthly fluctuations in food and energy prices because we are forced to buy these commodities every month! 

The spike in oil prices in mid-2008, when crude spiked to almost $150 per barrel is a prime example.  While that spike in oil prices was short-lived, and oil fell back to the $30s by December (six months later), many consumers were running out of gas on freeways all across the nation because they could not afford to put gas in their cars.  Many consumers were living paycheck to paycheck, and the jump in fuel prices was enough to cause them to run out of money in between pay periods. While it may make sense for economists to remove that spike in oil prices from the calculation of core inflation, (so that they can see the “true” long-term trend over time), the average citizen didn’t feel any better about their bank account dwindling.

As we move into the summer driving season, we are already seeing gasoline prices approach $5 per gallon at the pump.  There are many factors that affect gasoline prices, and some pundits are claiming that we will see a $0.25 per gallon decrease in prices shortly.  I am skeptical.  Due to the weaker dollar, countries in Europe and elsewhere are actually buying gasoline from U.S. refiners (because it is cheaper in euros, etc.)  This increased demand is putting upward pressure on prices.  Also, refiners are not operating at full capacity, because demand, frankly, has been very weak. 

One of the most frustrating ironies of the current commodity price bubble is that inventories are very high for oil and many other commodities and demand is low.  These conditions should result in lower prices, but due to a variety of factors, including the weak dollar, prices are at historic highs for most commodities.  More disturbing is the fact that we have now experienced high commodity prices for such an extended period of time that, even if prices fall and stay low, we will very likely see elevated prices at the pump, grocery store, retailer, etc., for a long time to come because the input prices for manufacturers have forced them to pass-on their higher costs to us.

I believe that the Fed will be forced to begin raising interest rates very soon. This should pressure commodity prices as the dollar will strengthen and economic activity will slow, bringing at least domestic demand down.  However, the prices we face in our everyday lives will very likely remain high for a long time to come, even though the monthly measures of inflation will indicate that inflation is under control.

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