On the CPI

A James Alexander post 

We have written on the causes of the oil price collapse and why it isn’t very good news, mostly just a consequence of falling AD, or at least a lot less fast growth in AD than expected.

US CPI showed it bouncing along the bottom again in November 2015 .Yet we have to put up with the usual charts of CPI excluding volatile items like food and energy – or anything not going up fast enough to prove the inflation-phobics right.

When CPI is high this asymmetry of reaction is sickening as the inflation-phobics worry about the public being fooled by temporarily high oil prices (or whatever) into thinking a high headline will translate into an unanchoring of inflation expectations. Unanchored inflation expectations are, apparently, incredibly dangerous as they are assumed to directly drive inflation into a never-ending upwardly vicious circle. Only counterproductively aggressive Fed action could prevent this situation from getting out of hand.

In fact, successful monetary policy should un-anchor inflation expectations: how else will velocity of circulation be driven upwards to drive NGDP higher when necessary? It’s a feature of monetary policy not a bug. It is also known as the hot-potato monster.

When headline is low all the experts “know” it’s going to bounce back and few worry about the downside of unanchored inflation expectations. Suddenly the public is trusted to keep their expectations “well-anchored”. Mean reversion is a fact, isn’t it?

This is all highly confusing. But will headline inflation really bounce back up as the Fed and mainstream macro forecast? For sure, as the drops in energy prices must eventually come to an end they must also eventually drop out of headline inflation indices. But if the energy price drops are mostly a symptom of weak demand, as Market Monetarists suspect, then at least part of the faster rising prices in other parts of the economy are also temporary as consumers resources are only redirected in a one-off move, and those non-energy prices must also slow. “Core CPI” will thus fall back to headline CPI and not the other way around.

One way to look at this is to assume 100 total money units and that velocity is constant. Assume 20 units are of money are spent on food and energy and 80 on “other items”. If the price of food and energy drops by 25% and the demand curve is inelastic, 15 units will be spent on food and energy and 5 units redirected to chasing “other items”. If there is no additional money injected into the economy the relative increase in demand for “other items” will be seen as just a redirection of resources. No new “other items” are produced and the producers of the “other items” will just take the gain off the food and energy producers, thank you very much. The overall price level will remain unchanged as will overall production.

If we constructed a core “other items” price index then we would see inflation of nearly 6% (5/85). But should monetary policy really be changed just for a core items index temporarily inflated by a fall in prices elsewhere in the economy? Of course not.

The numerous alternatives for core inflation show a lovely, but inevitable, range around the headline 0.5%, and you can make a good case for any of them. Shelter is a particularly good candidate to be excluded given the complexity of creating a reliable index of actual rent for a whole economy and the even tougher task of creating an index of Owners Equivalent Rent for the majority of households who are owner occupiers. This latter group’s assumed benefit takes up 25% of the CPI basket with their “benefit in kind”. Excluding shelter, inflation was a negative 0.8% YoY in November 2015. Sure “services” inflation is 2.5% but services less shelter is only 1.8%. And only 30% of the total basket.


It is the same for regions of the US. Some metro areas have inflation over 2.6% YoY, but so what? Others are in deflation. It’s one economy, one aggregate. Some go up, some go up less, some are flat and some go down. How could such a large economy as the US be anything else?


Those who focus at present on non-food and energy inflation are kidding themselves about an impending inflation take-off given NGDP is rapidly slowing and the Fed has been on a passive tightening bias for a year or more and is now actively tightening.

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