A Deflation Alert Hidden In The Latest Consumer Price Indicators

Consider the following three sentences — all taken from a single 250-word article in Friday’s Financial Times (January 27, 2023) reporting on the release this week of the Personal Consumption Expenditure Price Index (PCE) for December.

• “US stocks waver as inflation edges higher.”
• “US consumer spending softened in December even as inflation eased.”
• “Headline inflation fell to its lowest level in more than a year in December.”

These mixed messages encapsulate the confusion in the market, and in the minds of its interpreters. Fed Chairman Jerome Powell confessed his perplexity in a recent speech to the Brookings Institute.

• “The truth is that the path ahead for inflation remains highly uncertain.”

An inflection point is at hand, which is always the moment when prediction is most difficult. Multiple trends are fighting each other. There is a push-pull struggle going on, between the proponents of what in the finance world would be called the momentum trade (inflation is continuing, stay the course) and those who favor the mean reversion trade (inflation is ending, time to pivot).

The truth is that today’s PCE figure confirms that the post-pandemic inflationary episode which has bedeviled economists and markets for the past 18 months or so… is over. Definitively.

Whether policy-makers at the Federal Reserve and elsewhere recognize this, however, is uncertain, even doubtful. The traditional metrics they are focused on are very slow to pick up trend changes of this kind. Because of this, monetary policy always lags reality. The Fed was late in detecting inflation, and it will be late to respond to the end of the cycle. This risks feeding a pro-cyclical impetus into the real economy’s slowdown and, potentially, bringing on the recession that many fear.

Let’s do the numbers.

Too Many Metrics

The first problem is — there are too many numbers to choose from. To start with, every month the federal government publishes two “headline” inflation numbers. The Bureau of Labor Statistics (a branch of the Depart of Labor) releases the Consumer Price Index (CPI) typically around the 12^th of the month, and the Bureau of Economic Analysis (part of the Department of Commerce) publishes the Personal Consumption Expenditure Index (PCE) about two weeks later.

There are another dozen or so derivative measures of inflation, based on adjustments to either the CPI or the PCE. The Dallas Federal Reserve has its own version, as does the Atlanta Fed. The Cleveland Federal Reserve offers two other ways of doing the calculations. Across the spectrum of these various indicators, the purported level of inflation can vary by a factor of 2 to 1 or more. (See my earlier column on this topic, here.)

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Why are there so many different measurements of the same thing? Which one is best? Which one does the Federal Reserve mainly rely upon?

The PCE vs the CPI

The confusion begins with the two headline figures. The CPI and the PCE are designed to measure the same thing, so one should expect they will generally agree. Until Q2 2021 – when our inflation outbreak really got going – they did agree.

But since then, they have diverged significantly. The long term “gap” between the two metrics had been small (the CPI was less than 2/10^ths of a percent higher). But as inflation has accelerated, the gap has widened by a factor of 8.

This is troubling. If two bathroom scales give different answers, but the difference is small and consistent, we accept it as an ordinary variation in the manufacture or calibration of the two mechanisms. But if one scale starts producing answers that differ by a large and growing amount from the other, the conclusion must be that there is something wrong with one or both of them.

Part of the problem is clear: the CPI is badly broken. This has been known for a long time. Congressional hearings and formal studies of the problem dating back to the 1990’s identified a systematic over-estimation of inflation by the CPI. Economists have estimated that the measurement error has contributed trillions to the federal deficit. The CPI is the benchmark for cost of living adjustments for social security payments, military pensions, and many other entitlements. (These problems are detailed in a previous column, here.)

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The Federal Reserve itself recognized the problems with the CPI over twenty years ago, and replaced it with the PCE for purposes of setting monetary policy.

But the recent divergence is related to a more serious problem. It calls into question whether our conceptual understanding of inflation, and our techniques for measuring it, remain valid in a post-industrial, service-dominated and increasingly digital economy.

This intellectual reckoning is overdue. Inflation was “invented” as an economic concept when the economy was based on principally mass production of commoditized products. It “works” for assessing the cost of gasoline, say, or eggs. It works (to a point) for labor costs involving farm labor, hourly wages for “metal bending” jobs in a factory, or piece-work in the garment industry. But economists today struggle to apply it to services, to the compensation for knowledge work (e.g., doctors, chip designers, educators), to housing costs, and to products that embody high-tech features enabled by software, realtime data, and network connectivity.

Deflation Is Here

But even aside from these larger questions, the latest CPI and PCE figures raise doubts about the basis of current Fed policy.

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The Federal Reserve is still of the official view that inflation rages on. The year-over-year PCE is just over 5%. Even if that is 140 basis points lower than the CPI, it is still seen as a serious problem. “By any standard,” Chairman Powell said recently, “inflation remains much too high.”

But is it the case?

Since the summer – that is, over the last two quarters, which is long enough to establish a baseline – the PCE measure of inflation has essentially achieved the Fed’s 2% target, at a continuously compounded annual rate. (For November and December, it fell below 1%.)

The CPI is even lower for the last two quarters.

The fact is that inflation decelerated swiftly during the 2^nd half of 2022. The PCE fell from a 7.74% annual rate in the 1^st half of the year to a 2.09% rate in the 2^nd half. Similarly, the CPI dropped from 10.57% to 1.88%.

Returning to the matter of the difference between the two measures, annualizing the monthly changes shows that the discrepancy exploded in the 1^st half of 2022 – as inflation was accelerating. In the 2^nd half of the year, as inflation disappeared , the gap also disappeared.

In other words, the bathroom scale is most inaccurate precisely when it is most needed!

A 283 basis point difference is extraordinary. Something is out of whack.

The Lessons From All This

It is becoming clear (except apparently to the folks at the Federal Reserve, and Larry Summers) that the weather has changed.

1. The post-pandemic inflation surge, which began at the beginning of 2021 and peaked in he first half of 2022, has passed.
2. The inflationary episode was transitory after all.
3. The Fed’s official inflation target of 2% has already been achieved.
4. The prospect for deflation is real and should be heeded.
5. The Federal Reserve needs a new approach to measuring the price trends in the economy. The existing methods have become obsolete, and are producing inaccurate and misleading results.

The Fed’s response so far to this has been to search for new ways to parse the existing data, to justify preserving the illusion that inflation is still the most serious threat we face. Chairman Powell and others have taken to talking about Core and now “Super-Core” inflation (which excludes food, energy and housing costs), inflation for “non-housing services” as opposed to goods (most physical goods are showing clear deflation trends so ignoring them is a way to keep the heat on), wage inflation (which reflects labor market “tightness” — the pseudo-problem of the moment), etc. etc.

In any case, it is a tautology, isn’t it? If all the deflationary components are excluded from the calculus, it must accentuate the sense that inflation continues.

But the consensus is breaking, I think. For one thing, some at the Fed are willing to look at the shorter-term trends, which depict the actual state of affairs more accurately than the traditional year-over-year metric. In a recent speech at the University of Chicago, Vice Chair Lael Brainard adopted this perspective and acknowledged much of what this column has laid out — namely that inflation has slowed and is close to the target now.

• “Inflation in December is likely to have run at around a 2.3 percent annualized pace on a 3- and 6-month basis, as compared with 5.1 percent on a 12-month basis.”

Still, Brainard’s speech was full of classic bureaucratic swagger: “Inflation is high,” she assured her audience, “and it will take time and resolve to get it back down to 2 percent. We are determined to stay the course… Policy will need to be sufficiently restrictive for some time to make sure inflation returns to 2 percent on a sustained basis.”

One hopes that this mixed message is intentional, and does not reflect (as it might) a more fundamental confusion about what is really happening in the economy.

In any case, the brunt of Fed policy today is just this sort of Tough Talk. It is the recourse of an institution that surely understands it can do nothing about the supply-constraints that have been the main cause of the inflationary surge, but fears that it can’t afford to be seen as doing nothing. I don’t mind the tough talk, but we should all be concerned about the possible misapprehension of the clear facts of the situation, which could lead to gratuitous, and potentially grievous, policy errors.