CPI Unchanged, Yet Inflation is Stirring
On the surface, Friday's report on the Consumer Price Index (CPI) would seem to suggest that American inflation is firmly in check. The seasonally adjusted CPI was essentially unchanged in January, implying that prices for goods and services did not rise significantly in the US. However, the huge price drop in energy prices due to the worldwide oil glut has masked rising prices in most other areas of the economy, making the overall CPI somewhat misleading.
The core CPI, which is the measure of consumer prices without food and energy factored in, rose 0.3% in January as compared to December 2015. That increase brings the total year-over-year January core inflation figure to 2.2% — the largest increase in almost 4 years, following up on the 2.1% year-over-year core inflation in December. The corresponding year-over-year increase in overall inflation was 1.4% (not seasonally adjusted).
The Federal Reserve has set a target of a stable 2% inflation rate to maintain a healthy economy, so how is this report likely to affect their upcoming actions? Will they focus on the core inflation rate, collective consumer prices, or look at something completely different?
CPI vs. PCEPI
The daily assessment of prices by an average consumer is commonly based on two of the most volatile components of prices: gas for your car and the food you purchase at the grocery store. You feel lousy when you pull up to the gas station and find that gas went up by ten cents, or that milk costs a half-dollar more. Meanwhile, you get an extra spring in your step when gas or grocery prices fall by that same amount. The effect on your wallet is tangible over time, but gas prices are so volatile that you may experience disproportionate joy and pain at the pump several times in the same week.
In comparison, CPI is an assessment of a "standard basket of goods and services" that represents what the average consumer buys in a typical year. Food and energy costs are more volatile than the other measures like clothing, medical care, vehicles, furniture, etc. and their effects on a monthly basis can overstate or understate inflation. That is why a comparison of the core rate and the overall rate is important, and also why year-over-year readings have great significance compared to the monthly average.
When the Fed looks at inflation, it considers the short-term view but focuses on the longer and broader perspective and does not depend solely on CPI. The Fed's preferred measure of inflation is the Personal Consumption Expenditure Price Index (PCEPI), arguably the clumsiest acronym coming out of Washington.
CPI and PCEPI are similar, but use different data sources. CPI measures direct consumer purchases through consumer surveys, while PCEPI measures all purchases made on behalf of consumers through business surveys. As an example, for medical expenses, CPI only measures your co-payments while PCEPI includes the other costs related to your care such as employer-based insurance.
In essence, CPI is the measure most relevant to your daily life, while PCEPI is the measure most relevant to the broader economy.
So how do these metrics compare? Historically, CPI is usually slightly higher than PCEPI but energy prices have distorted the relationship. For December 2015 (the last available data), PCEPI rose 0.6% for the month and 1.4% year over year. That compares to a 0.1% drop in CPI in December and a 0.7% year-over-year reading.
All inflation measures may be low by historic standards, but they are nonetheless rising. Meanwhile, as the drop in oil prices stabilizes, the year-over-year readings that reflect 2015's plummeting oil prices will no longer be a factor and the core CPI should start to rise and pull closer to the overall CPI — even if oil prices simply stay stable and do not rise.
In short, inflation may be flat as reported in the news thanks to oil, but it is climbing in ways that suggest the Fed is on the right track.
Why Inflation Control is Important
Inflation does not turn on a dime based on interest rates. Inflation can rapidly gain momentum, like a snowball rolling down a hill and increasing in size and strength as it goes. Just as it takes time for the economy to heat up, it takes time for it to cool down.
With our current near-zero inflation, the Fed finds itself on the other end of the economic temperature curve. To raise rates, they must conclude that any hike to normalize interest rates will not shove inflation down further and stall our current economic growth. The CPI readings, particularly the core CPI, are likely to provide a counterbalance to the mostly grim economic news of 2016 so far — especially if the PCEPI numbers for January follow suit.
While energy prices are considered one of the most volatile elements of the CPI, that volatility has recently been centered on a much lower baseline price than usual. Thus, while economists and the Fed realize the situation is predictable in the short term, it remains transient over the long term. Once the weaker players in the oil market have been driven out (including producers of costly-to-extract shale oil in the US) and/or the Saudis decide to exercise production restraint once again (they have been deliberately overproducing for a few years to put pressure on these same players), oil prices will rise and make inflation by either standard look considerably worse.
Knowing this, the Fed is trying to stay ahead of potential inflationary pressures — but like the rest of us, they have no way to predict how long the game of chicken among oil producers and oil-producing countries will last. The Fed must simultaneously worry about short-term deflation and long-term inflation, making it likely that whenever the rate increases take place, they will be small as advertised.
Even though the Fed finally raised interest rates in December and ended the "will they or won't they" approach that consumed financial media for more than a year, there is still significant over-analysis and overreaction about when the next rate hike will take effect and how large that hike will be. As a long-term investor, remind yourself that, if the US continues to steer clear of recession, interest rates will likely go up in slow increments over time, and eventually reach more normal levels. The daily static can obscure that longer-term trend.
The stock market is likely to remain volatile, and the bond market is becoming increasingly volatile as well, as traders drive bond yields up and down depending on their immediate analysis of the next Fed action. Stick with your diversified plan and avoid overreaction
However, the closer you are to retirement age and the need to withdraw your funds, the more important the daily gyrations are to you. Remember to shift your portfolio balance toward less risky investments as you approach your retirement date — if you do not have a target plan or similar fund that does the adjusting for you.
In the meantime, enjoy your low gas prices while they last and watch out for slow price increases at the grocery store and other consumer outlets. Inflation may be somewhat dormant, but it's not dead.