Expert Commentary

The Basket Cases of Inflation and Deflation (The Fed dealing with an increasingly sticky wicket)

You should take measures of price changes with a pinch of salt.

In August, the annual percentage change in Core CPI in the U.S. (the consumer price index less food and energy) was recorded at 1.7%. That was higher than the 1.6% expected by economists. On the face of it, price inflation in the U.S. moved up. But did it?

There are lies, damn lies and statistics so they say, and measuring changes in consumer prices certainly comes into that realm. When devising indices such as the consumer price index, decisions must be made as to its construction. What items go into it and what their weightings are profoundly affects the final number, how price inflation is reported and, consequently, thought of. The eggheads who devise these statistics try to make the CPI a representative basket of goods and services. Consider, though, that 40% of the rise in Core CPI in August was accounted for by the increase in used car prices. Used car prices should probably be in a basket of goods and services but, unless you are a used car dealer, the changes in their prices is not as important to merit such a weighting. Everyone’s basket of price inflation or deflation will be slightly different.

The Fed has tried to splice out price inflation into so-called Sticky prices and Flexible prices. Sticky prices are those that don’t change that often whilst flexible prices do. A detailed study of the 350 spending categories in the CPI by economists Mark Bils and Peter Klenow (now that’s dedication!) found that half of these categories changed their prices at least every 4.3 months. Some categories changed their prices much more frequently; price changes for tomatoes, for example, occurred every three weeks. And some goods, like coin-operated laundries, changed prices on average only every 6½ years or so.

The chart below shows the annual percentage change in Sticky Core CPI versus Flexible Core CPI. As you can see, whereas Sticky Core CPI has always been above zero, Flexible Core CPI has dipped below zero on nine occasions since the start of the data in 1967. Interestingly, eight of those periods of price deflation have occurred since 2000 when monetary policy in the U.S. has been its loosest in history.

Flexible Core CPI continues to sport price deflation, albeit at a slower rate than the -3.4% recorded in June. Nonetheless, it continues to be a drag on overall consumer price growth.

Meanwhile, in other news, Wells Fargo is reporting reduced demand for loans from customers. Now that’s proper deflation: debt deflation.

US Consumer Prices YoY%