Inflation Continues To Run Well Below Target As Revised Seasonal Adjustments Reduce Volatility

by: Ed Dolan

Data released this week by the Bureau of Labor Statistics show that consumer price inflation continues to run well below target. The all-items CPI for urban consumers rose at a seasonally adjusted annual rate of 1.75 percent in January, compared with the Fed's inflation target of 2 percent. The seasonally adjusted core inflation rate for the month, which removes the effect of food and energy prices, was 1.54 percent.

The BLS makes seasonal adjustments to the CPI in an attempt to remove the effects of price changes that happen at predictable times each year, such as more expensive gasoline when the summer driving season starts and lower food prices in the harvest season. Although the adjustments are supposed to give a more accurate picture of underlying trends, as the structure of the economy changes the adjustment factors become outdated. Accordingly, the BLS revises its seasonal adjustment factors early each year. The following chart shows that the revisions remove much of the previously reported month-to-month volatility in the CPI while leaving the average inflation rate essentially unchanged.

Another way to overcome the problem of seasonal adjustment is to look at year-on-year changes in the CPI rather than monthly changes. The year-on-year inflation rate in the all-items CPI for January (that is, the change from January 2013 to January 2014) was 1.56 percent. The next chart also shows the year-on-year core inflation rate, which was 1.62 percent. Both the all-items and core inflation rates have been trending downward over the past two years.

Investors and policy makers try to consider likely future inflation developments when they make their decisions as well as past trends. The prices of Treasury Inflation Protected Securities, or TIPS, are one source of information on inflation expectations. The difference between the prices of TIPS and the prices of ordinary Treasury securities of similar maturities tends to increase as the expected rate of inflation increases. Each month the Cleveland Fed publishes data on inflation expectations based on an analysis of TIPS prices. As the next chart shows, the rate of inflation expected over the next five and next 10 years rose in the second half of 2013. Since then, however, inflation expectations have leveled off. Like past inflation, expected inflation remains well below the Fed's 2 percent target.

The bottom line: So far, the gradually strengthening recovery of the U.S. economy has had little or no impact on inflation. An upside breakout of consumer prices remains among the least of dangers facing the U.S. economy for the foreseeable future.