Where do we stand with inflation and why are small changes such a big deal?


Written by: Jon McGraw

As noted in the recent CPI release, inflation has certainly remained tempered as of late.

After a few deflationary year-over-year results during the troughing of the financial crisis, the average 12-month rolling inflation number has hovered just over 2% in the last three years. To put it into perspective, the average year-over-year change in U.S. inflation since the creation of the Federal Reserve in 1913 has been 3.3%—a period that includes a depression, two world wars, several stretches of benign economic growth and industrial/manufacturing/superpower emergence, as well a stint of stagflation and energy price spikes, ending with the financial crisis and its aftermath.

Even with the creation of a central bank a century ago, which was intended to add a higher degree of formal monetary stability, we have experienced several deflationary episodes as well as inflationary ones—albeit fewer than we did before the creation of the central bank (deflation and inflation episodes in the latter half of the 19th century were much more extreme and pervasive—with fewer tools/incentive to combat them). Nevertheless, today’s inflation figure is remarkably low considering the more extreme experiences faced in many other nations.

Many emerging nations are still fighting the inflation war. (For those who like data, the highest year-over-year inflation number in the U.S. during this period was 24% in June 1920, and the lowest was deflation of -16% just a year later…although several of the depression years featured strong deflation. In the 1,200 rolling 12-month periods since the Fed was created, 7% were deflationary by more than -2%, 44% were inflationary by more than +3%, and the remaining 51% of years were in a range between the -2% and +3%.)

Given this history, why do we care about these small numbers?

To put it in perspective, higher inflation is generally related to either overheating growth, including excessive money supply in the financial system, high commodity costs and/or a depreciating currency, the latter of which can be a byproduct of these other factors. Even prior to Ben Bernanke’s academic focus on the Great Depression and policy errors made during it, and an overall fear of deflationary outcomes, the argument that some inflation as a byproduct of growth has been considered an acceptable aim in economic circles and in the minds of government policymaker. The Fed’s current stated target is 2%, while an informal 1.5-2.0% range has been in effect behind the scenes for several years. So, many agree that some inflation is better than none. We’d been hovering right around that target, but have now dipped below it, which no doubt the Fed is watching closely in their assessments of QE extension vs. taper.

The inflation focus is usually on the traditional consumer price index, a series for which we have an abundance of long-term data. Despite flaws and ongoing arguments as to why CPI isn’t a perfect measure to use for inflation in the first place, it continues to evolve as the most comprehensive tool the government has at its disposal. Those in the camp to maintain a sustainable Social Security system like it (low inflation calculation = better), but like its cousin, chained CPI, even more since it tends to offer more year-to-year stability. (Modern inflation calculations allow for a ‘substitution effect,’ or in English; an implied behavior of folks to buy more hamburger when chicken gets too expensive, so weightings to chicken in the inflation measure drop due to those types of assumed choices.)

Inflation impacts also vary based on the audience. Progressively cheaper yet more powerful consumer electronic devices are great for those needing them frequently, and represent a deflationary pressure, as are lower food prices following a strong harvest season with ample inventories. On the other hand, medical care and college tuition inflation in the double-digits is problematic for retired Aunt Millies and students, respectively, but those in between don’t really care so much. This limits the impact compared to more widespread inflation that affects all income levels in a society (caused by such things as high energy or grain prices) and can be a catalyst for social unrest or even revolution in less stable societies—as we witnessed in the Arab Spring. Piecemeal inflation for different products/services for distinct groups in the developed world is much more subtle, but no less problematic.

The Atlanta Fed branch produces unique reports on ‘sticky’ and ‘flexible’ price CPI that add additional color to the inflation persistence of various items. The sticky list includes owners’ equivalent rent, actual rent, medical care, personal goods, etc., while the flexible list includes more volatile items like natural gas, gasoline, vehicles and hotel rooms.

Economists are still looking for the ideal way to measure inflation, but the consensus is that too much is bad (something we already knew, as it often coincides with higher commodity costs, hoarding of goods, accompanying higher interest rates, etc.), but so is too little. A deflationary spiral can have very negative side effects, as in lack of investment, hoarding of cash and ballooning of ‘real’ values of debt (for the opposite reason that inflation helps deflate values of debt over the long-term, making it a subtle policy tool for some firms and nations). Some inflation, that ‘Goldilocks’ level, seems to be accepted as an ideal policy goal. This is manageable quantitatively to some extent, but with the labor mandate added in, the Fed may end up having to make some difficult choices.

The bottom line is that right now inflation continues to appear restrained. Perhaps there is also a bit of potential embedded inflation exposure not being reflected, due to prices of imported energy and consumer goods (the latter being 25% of core CPI and just under 20% of the headline figure) kept lower by a stronger dollar. If the dollar weakens significantly, we may see ‘imported’ inflation again perk up.

To get ahead of inflation trends, what do we watch?  Wage inflation could be a good indicator. It has been slow in the past few years due to large amounts of labor slack and ‘filling the hole’ caused by the recession. In fact, the great recession period was the first time in a long while that expectations for rising income actually reversed—workers didn’t expect to even get a cost-of-living raise, let alone anything beyond that—but that pessimism is beginning to dissipate and as wage inflation enters the picture we believe it could have an exponential impact.


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