The Independent Market Observer

Looking at Inflation: Objects in Mirror Are Closer Than They Appear

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 16, 2015 3:14:00 PM

and tagged Commentary

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inflationWe know the Federal Reserve is worried about inflation being too low, and yesterday’s figures seem to substantiate that fear. With headline inflation over the past month down by 0.2 percent, and flat over the past year, it seems that prices are indeed just sitting there.

As this post's title suggests, though, those numbers come from looking in a mirror. In fact, inflation is much closer than they would suggest. Let’s take a detailed look.

Headline inflation versus core inflation

The first thing to understand is the difference between headline inflation and what is known as core inflation. Headline inflation includes everything, including energy and food. This is a good number if you want to understand how actual consumers experience price changes because, of course, energy and food are significant parts of the budgets of real people.

Core inflation, on the other hand, excludes energy and food, which would seem to make it a poor indicator for people who eat, drive, or heat their homes. The reason it’s important is that both food and energy prices are highly volatile—and not really driven by the rest of the economy. As such, if you exclude them, you have a much better indicator of what is really happening with the underlying trends.

Exploring the gap

Although headline inflation is flat, core inflation ticked up last month by 0.2 percent, even as the headline rate dropped, and it is up 1.9 percent for the past year. This is very close to the Fed’s target and suggests that the underlying inflation trend is not low at all.

There is a very big gap between the two measures of inflation, which prompts me to ask why, especially if core inflation is a better indicator of underlying trends. Could the core number be incorrect this time?

In fact, the reason for the gap is almost entirely the drop in gasoline prices, which were down 4.7 percent last month alone. Without the significant drop in these prices, the headline number would be much higher. Unless we expect gasoline prices to continue to drop, then, the core inflation number is still a better indicator.

What does it mean?

We can draw two conclusions from this. First, we do not expect gasoline prices to continue dropping but to normalize at current levels, or even increase. Starting next year, the annual changes in gasoline prices will be based on much lower initial levels. Inflation is measured on an annual basis, and energy prices dropped hard at the start of this year—meaning that gasoline in particular will no longer be a downward pull. This alone will bring headline inflation much closer to the core.

The second conclusion is that without that downward pull from energy prices—which also translates indirectly into lower price increases in other areas, as everything uses energy in one way or another—we can expect to see higher core inflation as well.

Keep in mind that there are other areas starting to show higher inflation levels: 

  • Housing, for example, showed rents rising by 0.4 percent for the month, the highest since October 2007.
  • Household furnishings rose 0.3 percent, the first increase in five months.
  • Professional services, including medical care and education, also rose at a rate faster than in recent history.

All of these trends look likely to persist, as job markets continue to tighten and the housing market continues to improve.

So, is higher inflation approaching?

Two factors, then, point to higher inflation across the board in the near future. When gasoline adjustments normalize, the headline rate will rise. And with multiple areas showing accelerating price increases, the core will rise as well.

An increase in the headline rate will not be a problem. In fact, it will probably help the Fed’s decision-making process. An increase in the core rate, though, may well take it above the Fed’s target range—and force the Fed to start weighing growth against inflation in a way it has not had to do for years.

Either way, it looks like inflation is indeed catching up with us—even faster than the mirror-based data suggests.

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