CPI trending higher, NGDP growth lower – monetary policy must go easy

A James Alexander post

The echoes of 2008 became stronger last week as both headline and core US inflation as measured by the CPI rose faster than expected. It is a very dangerous cocktail when the claque sees inflation yet nominal growth expectations are weak. It caused the Great Recession when central banks misread the situation. Hopefully they will have learned their lesson, but the current tightening bias of the Fed doesn’t give us much confidence.

Go to Twitter and enter “core CPI” and you’d see a welter of inflation hawks trumpeting the now clear upward trend in CPI. These were typical:

“John P. Hussman‏@hussmanjp

Not to bust anyone’s NIRP bubble, but while YOY CPI inflation is 1.34% due to food & energy, YOY core inflation rose to 2.22% in January.

Michael Ashton‏@inflation_guy

I did NOT realize until just now that this month’s 0.29% rise in core CPI was the highest m/m since 2006.

Carl Quintanilla‏@carlquintanilla

Beating estimates in past 2 wks: * core CPI * core PPI * hourly wages * retail sales * Ind. Prod


It is hard to disagree with the charts over the short-term.


The longer term is a bit different, of course.


But does it mean the Fed should take act? The markets decided the new information content from the CPI data was virtually nil.

Why were markets so calm?

 1. The Fed looks at the far superior Personal Consumption Expenditure price index or deflator. It is composed of the dozens of individual price index estimates used to deflate nominal spending to derive a supposedly “real” level of spending for each category of goods and services purchased. Compiling these indexes is a task fraught with pitfalls. At least PCE uses actual data on expenditure rather than the CPI surveys of consumer expenditure as a starting point. It also includes items bought on behalf of consumers by their employers like healthcare and insurance. It also estimates the financial benefit of services not paid for, like banking.

PCE has historically run 0.5% lower than CPI and been far less prone to volatility. The PCE deflator much more quickly captures substitution effects, as consumers switch purchases from higher priced goods and services to lower ones, or like today (probably) switching spending from energy and goods sectors in deflation to housing, healthcare and education – increasing the pace of service sector inflation? Looking just at the service sector will be very misleading.

The housing element of CPI remains a minefield as Kevin Erdmann constantly reminds us. Artificial shortages abound and have significant effects. Artificial demand in education thanks to state-subsidised loans  also leads to price pressure, and we all know about restrictive practices in medicine.

 2. The Fed has made it clear since the market turbulence that it caused will be incorporated into its future actions.

 3. Nominal growth is still horribly weak. Core CPI may be trending up but nominal Personal Consumer Expenditure, i.e. not deflated, remains stuck in a 3% trend – down from the 4%-5% trend achieved towards the end of QE3 when nominal spending peaked at 4.96% in August 2014.

 I remain unconvinced that PCE will move up meaningfully towards any higher trend in CPI. Nominal growth, historic and expected, remains just too low. And, of course, active monetary policy is clearly biased towards tightening.

And here we may get a horrible echo of 2008 where nominal growth expectations are flat or falling but the claque of inflation hawks is fretting about cost-push inflation. The Fed should ignore the claque and laser-lie focus on nominal growth expectations, but will they?

The other echo of 2008 comes from the accounting identity that if inflation really is rising and nominal growth really is weakening then the counterpart has to be in weakening RGDP and weakening productivity. And this is precisely what we are seeing. RGDP is weak and so is productivity.

I am a bit more more sanguine about productivity, even if arithmetically it is shown to fall. It may not be falling as the deflator may be too high, underestimating real growth, and thus productivity growth. Why is this?

First, because it is so fiendishly difficult to directly measure productivity, especially in our service-sector dominated world. There are hardly any detailed temporal or cross-border studies of productivity by industry segment, just windy, useless, macro level stuff by country. Output of physical stuff is relatively easy to measure in both nominal and real terms, as long as the quality of the stuff doesn’t change too much: a bushel of wheat, a barrel of oil, a table. But think of a college degree, a cable subscription or a visit to the dental hygienist and things get trickier.

Quality issues are very, very tricky to gauge. It should be for economic historians and politicians to argue about the quality of the nominal growth, the balance between real and inflation within the nominal figure.

Second, it will have got very difficult with the rise of the web to really figure out what is happening to the real economy. It is important to figure it out, but is really hard. Diane Coyle wrote this thought-provoking piece on Digitally Disrupted GDP recently:

 Digital technologies are having dramatic impacts on consumers, businesses, and markets. These developments have reignited the debate over the definition and measurement of common economic statistics such as GDP. This column examines the measurement challenges posed by digital innovation on the economic landscape. It shows how existing approaches are unable to capture certain elements of the consumer surplus created by digital innovation. It further demonstrates how they can misrepresent market-level shifts, leading to false assessments of production and growth.

Third, we think it will rise once the nominal economy begins to run hot again. Why should businesses invest to economise on labour when labour is so plentiful? Why should businesses invest when sales are so weak and expected to remain so?

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.

Headline CPI could now stay below Core CPI for 10 years

A James Alexander post

The inflation doom-mongers are out again with today’s US Consumer Price Index numbers and, to a lesser extent, in the UK where, headline inflation really is just too low for most hawks to shout too much about steady core inflation.

We must all ignore “headline” inflation and focus on “core” inflation. Core is the measure for inflation-worriers because … it is currently higher than headline. When headline was above core they worried about headline, naturally enough. Normal service will be resumed as there will be a very short period before headline inflation goes back above core inflation, pulling up the latter. But will it?

In the UK everything about CPI (and the RPI in its former life) has to be taken with a large health-warning since the index is not a proper economic statistic because it is never revised, but it remains a very politically and financially sensitive one nonetheless.

UK headline inflation (CPI All Items) was above core (CPI excluding food, energy, alcoholic beverages and tobacco) for ten years in a row before falling below core one and half years ago – by an average of 70bps per annum. Some feat. Although this does include 2008 (the notoriously heavily revised year for proper economic statistics) when the gap was 200bps.

The story in the US is much the same. Although it looks as if headline bounces around the core trend, for the same 10 years (2003-2013) as in the UK headline was 50bps above core inflation.


Is there any reason not to think that we may have ten years of headline being below core? Not really. These things should be fairly random and even out over the very long term. But you just know the inflation-worriers won’t be pointing this out.