A Look at the Volatility Lurking Inside the Low Inflation Rate
“The trick is this: keep your eye on the ball. Even when you can’t see the ball.” —Tom Robbins, American novelist
Of all the commonly tracked economic data reports, inflation is the trickiest. First, it’s a difficult concept to really understand, unlike a jobs report or retail sales. Inflation isn’t just cost-of-living changes or the prices of certain individual goods or services going up and down.
It’s also hard to measure. The Bureau of Labor Statistics and Bureau of Economic Analysis both attempt to do so on a monthly basis, and do an admirable job at it, if still facing some underlying issues.
The most notable problem is simply volatility among the underlying components. In order to try and measure an overall loss in purchasing power, which is what inflation actually is, we measure the change in prices among a bunch of spending buckets. There have been a series of incidences of single sectors having major impacts on the overall index, most notably the 2015 surge in energy prices, or the sharp drop in wireless telephone services with unlimited data programs introduced in 2017, or appliance prices jumping on import tariffs in 2018, or … the list goes on. As we said earlier, none of this being actual inflation, or deflation, despite having pretty big effects on the headline and core inflation indices.
With that somewhat wordy preamble, let’s check in to see how volatility among the inflation components has behaved since the pandemic began. The chart below looks at the average three-month deviation in inflation rates among underlying components as a proxy. Essentially, this is a look at how volatile inflation has been on average for each component. As you readers may have suspected, the pandemic has not led to a drop in volatility, but rather consistently the most volatility we’ve seen since the BLS has been measuring this amount of detail back to 1990.
The volatility has closely tracked changes in how stringent pandemic response policy is at any given time, things like school closures or other stay-at-home metrics. While these restrictions are being rolled back on better COVID-19 infection rates in March, in February conditions were still strict and inflation volatility rose in tandem.
The headline for the Consumer Price Index for February, released last week, showed that inflation was lower than expectations. The core rate increased only 1.3% compared to February 2020, down from 1.4% the prior month. While this validates our priors that inflation is not an issue currently, talking about such rates while all this turmoil happens under the surface makes little sense. Just look at the chart below to see the disparate performance among inflation buckets, where many components seeing price increases while others are declining rapidly.
We know these changes are a result of the pandemic, so it’s difficult to use these as any proxy for what inflation will look like over the rest of the recovery, or a year from now, or even the next few months.
Home appliances and cars have been essential for getting through the pandemic, a sign of the population taking safety measures to build up more space to work at home and avoid public transportation, respectively. Deflation in hotel and public transportation prices by 15% from a year ago is a flip side of that. What does either say about underlying inflation pressures? Not much, if anything at all.
The rise in medical services inflation and drop in financial services are more interesting, less likely to be pandemic induced. Retail brokers continue to drop transaction fees, which we can call a more durable deflationary pressure. Medical service inflation is due to a one-time rise in Medicare payment rates, which will ease in coming months from its current 12-year peak in inflation rate. This is all to say headlines are showing some more durable pressures, but will be completely overshadowed by volatile, pandemic-induced moves until the coronavirus is in the rearview mirror, and likely a while after that as conditions normalize.
How does one cope? Fortunately for us, there are quite a few economists trying to answer the same questions. Our favorite response to dealing with volatility is to simply use the median price increase, totally muting the volatile components. This has been an extremely reliable indicator of where core inflation will settle once the noise subsides. The chart below looks at this measure from a year-over-year change perspective (in blue) as well as a monthly annualized measure (in red).
What we find is that, in spite of the headline weakness, median CPI rose by an annualized 2.8% in February, the largest increase since last July on the first round of reopenings, which eventually reversed. The year-over-year rate remains low at 2.1%, as the prior three months had all been quite weak for median CPI, but perhaps we are seeing some stabilization.
As a reminder, median CPI typically runs 50-150 basis points above the Federal Reserve’s preferred core PCE measure it uses to determine policy, so this level should not change its uber dovish approach.
This exercise in understanding what’s happening to inflation right now is to remind us all of the complexities around the question “is inflation going to be a problem?” in the coming months and years. While we believe it will not be, at least not for the next few years, it is never an easy question to answer. In fact, the next few months should definitely show a sharp rise in year-over-year inflation rates, as measured by the BLS and others. This is simply going to come from much lower 2020 comps, as prices declined fairly sharply in the early months of the pandemic. This, like the volatile pandemic-induced conditions, will not be inflation as we care about it and as it matters for monetary policy.
Instead, we like to keep our eyes on cumulative progress to fill economic capacity, a better indicator of how much room we have to run before overheating. The chart below is a favorite of ours, using "Job Openings and Labor Turnover Survey" data released this past week. The ratio of current job openings to the number of unemployed available to fill them is a tidy measure of cumulative labor market progress. And it is indeed progressing, but at 0.7 jobs available per unemployed, remains far below what we saw in 2018-2020 when we finally saw wage and prices increase on a more sustained basis.
It is likely the recent stimulus bill will accelerate progress towards returning to pre-pandemic heights, but we’re comfortable saying there remains a distance to go.
Noise versus signal. Separating the two is the biggest challenge in economic analysis. All of this pandemic-induced volatility in, well, everything means that it’s difficult to keep focus on these longer-term, less volatile concepts like median CPI and job availability. However, doing so will be essential to figuring out how the next few years will progress. We won’t get it exactly right, but keying on the right indicators should help us be less wrong.
The Week Ahead …
This week we get to find out exactly how the Fed, helmed by Chairman Jerome Powell, views these inflation developments. Our expectation is that it is likely to shrug them off for the time being. The Federal Open Market Committee meets Tuesday and Wednesday, with a statement and its quarterly economic projections set to be released at Wednesday, 2 p.m. On the data front, we’ll watch Tuesday’s retail sales index to see whether consumers spent their new $600 checks or were kept inside during February’s poor weather. Expect another gain in online shopping, either way.