We’ll continue our discussion about US inflation today with 2 separate topics:
#1: Do “core” Consumer Price Index (CPI) or Personal Consumption Expenditure (PCE) Price Index data do a better job as early indicators of changes in US inflation trends? In both cases “core” means measuring price changes excluding food and energy, 2 necessary but volatile commodity types that may skew headline inflation calculations.
As we did Thursday night, we’ll focus on the 1960 – 1982 timeframe; the chart below shows annual core CPI inflation (blue), core PCE inflation (red) and headline CPI inflation (green). We’ve noted November 1970’s 5-6 percent inflation to illustrate the peak caused by the Great Society’s social programs and Vietnam War spending, as we discussed last week. After President Nixon’s price controls modestly reduced inflation from 1971 – 1973, oil shocks had large impacts (clearly visible in the 1974/1980 peaks below).
Two things to note about this data:
First, core PCE (red) typically gives lower inflation readings than core CPI (blue) due to differences in weighting and measurement. This is true even now: November 2020’s core CPI inflation was +1.7 percent while core PCE inflation was +1.4 percent.
Importantly, the Federal Reserve prefers the core PCE inflation index even though it reads systematically low relative to core CPI.
Second, core PCE and CPI actually tracked overall CPI inflation quite well at every important inflection until 1973. Then, headline inflation took off with the rising price of gasoline caused by the OPEC oil embargo. Core measurements miss those turns since energy is explicitly excluded, and only caught up some months later.
Also worth noting: core PCE did an especially bad job signaling the urgency of the US’ inflation problem in the late 1970s. The red line above (core PCE) did not even get back to its early 1975 highs. Paul Volcker was wise not to think this measure mattered…
Takeaway: since current inflation fears revolve around pandemic-related fiscal and monetary policy, we would say the 1965 – 1970 period is more analogous to today than the energy inflation-driven period of the mid – late 1970s. Both core and headline inflation did a good job of catching inflation’s rising tide back then, and they should do so again in the 2020s. We’ll keep watching all 3 measures carefully and (importantly) not overthink what they are trying to tell us.
#2: Almost a third (32.2 percent) of headline CPI inflation is tied to “shelter”, the cost of putting a roof over your head. Most of this measurement comes from a survey of homeowners, polling them regularly on how much they think it would cost to rent their house/apartment. This is called Owners’ Equivalent Rent (OER) and it is 24 percent of the entire CPI and 30 percent of core CPI. The other piece is regular rent, which is 8 percent of headline CPI and 10 percent of core CPI.
That makes OER/rent the single largest driver of CPI inflation; here is how those components have influenced headline inflation since 1960. Rent is in green, OER only goes back to 1983 and is in red, and headline CPI is in black.
Two points about this data:
First, you can see that shelter has gone from an input that pulls inflation lower (1960 – 1981) to one that either tracks overall inflation or actually increases the overall measured cost of living. The latter is especially true over the last 9 years (2013 – present). Both the green line (rent) and red line (OER) are well above the black line (overall inflation).
Second – and we find this a bit strange – US housing inflation has declined sharply since January 2020 (just visible on the rightmost part of the graph). At the start of last year rents were rising at 3.8 percent and OER by 3.3 percent. Both were stronger than headline CPI inflation of 2.5 percent.
As of December 2020 rents are only up 2.3 percent and OER by 2.2 percent, or over a percentage point less than the start of the year.
Takeaway: we can only assume that lower mortgage rates and terrible rental markets in major urban areas around the US are more than fully offsetting the overall strength in house prices, limiting rent/OER inflation. For those readers concerned with future measured inflation, these inputs will be critical to watch. It will be hard to get to +3 percent CPI inflation without OER/rent rising by at least as much as that.