The Top-Line and the Core CPI: A Tale of Two Inflations

Thank goodness for core! For those intent on staying positive on the future path of inflation, focusing like a laser beam on the so-called core rate of the consumer price index is essential to one's mental health.

Friday morning's report on the CPI offers a potent example. On the surface, there's bad news: top-line CPI rose 0.7% last month, the highest since September 2005's anomalous 1.2% surge. As a result, the CPI's annual pace as of May is a worrisome 2.7%. More troubling than the absolute level, is the trend. Since late last year, the CPI's annual rate of change has been climbing. As recently as last October, annual CPI was a mere 1.3%, which is lower by more than half when compared with the current inflation.

But optimism has a savior in the core CPI reading, which extracts the troublesome energy and food prices from the mix. By that standard, all is well. In a bubble universe where no one buys energy and food, inflation is worth barely a mention. The 0.1% rise in the core CPI last month was lower than April's 0.2%. In fact, the annual change in the core CPI through May is notable mainly for its descent over time. For the fourth month running, the 12-month change in the core CPI has fallen, posting just 2.3% for May, down from 2.9% in September 2006.

The question then becomes: which one speaks the truth? The answer, depends on each individual's perspective. Indeed, the central bank has a fondness for the core reading because it conveniently strips out the biggest pricing variable over which the Fed has no control: energy. Of course, this is true, so there's a case to be made for central banks focusing on the core. The hope, and it's not entirely unjustified, is that the Fed can execute a prudent monetary policy by ignoring food, and energy prices. If so, the benefits will eventually flow to the economy overall. By that standard, we can all rest easy.

But will reality eventually intrude and spoil that conceptual package? OPEC may be the mother of all exogenous pricing shocks that the Fed ignores in its appointed rounds. But, the masses can't afford such a cavalier view on energy prices.

It remains to be seen how long a divergence between the top-line, and the core CPI will run with no material impact on monetary or political policies. But this much is clear: if top-line CPI moves higher for long enough, there will be a political price to pay, in which case an economic impact, intended or not, may soon follow.

It's hard to imagine that Federal Reserve Chairman Bernanke won't find himself on the losing side of the debate in Congressional testimony if the top-line CPI runs at 3%-plus in the near future, even as the core CPI remains contained. The econometric logic that rationalizes a focus on core as a monetary signpost is lost on the man at the pump paying $60 to refuel his car. Members of Congress will spontaneously sympathize with their constituents on such issues, which in turn will foster calls to do whatever is necessary to relieve the financial suffering.

Invariably, the political pressure to bring relief to consumers paying more for energy runs the risk of stoking inflation. The connective tissue that binds the political to the economic isn't always obvious, but history suggests that the former will invariably affect the latter. In theory, the Fed could abet such pressures by refraining from an interest rate hike, or even lowering rates when monetary prudence suggests otherwise. Barring that, Congress may see fit to engage in an ambitious new program to redistribute wealth to the stricken masses paying more for gasoline. The opportunities for reactionary populist notions are endless in an energy bull market.

Don't let the serene core CPI fool you. The rise in top-line inflation, if it continues, will have consequences for the economy. Ideally, the top-line number will turn down, or at least stabilize, in concert with the top-line number. Until, and if that state of correlation arrives, there's reason to wonder what's coming.

Comments

[uurum:]

Thank you for your comments. Excessive focus on "CPI excluding food and energy" does not make sense to me. Food and energy are important components of inflation (and also deflation, at times).

2007 Jun 17 09:46 AM

[flow5:]

Calculating the rates of change in the CPI has been statistically exaggerated by the present practice of calculating the rates of change in terms of a base one year earlier, rather than from the base period of the index. For example, when I first started driving the base period for the CPI was 1967 = 100. Consumer prices in 1967 have increased 623% in terms of base year prices. In other words, a very substantial absolute increase in prices. But the base period keeps changing. Now the base period is 1982-84 = 100. And that assumes that the CPI is representative, which, as everyone knows, it is not.

2007 Jun 17 12:00 PM

[flow5:]

With the exception of hyperinflation, all the “flations” are the consequence of “too much money chasing too few goods and services”, or the opposite. Inflation represents a chronic “across-the-board” increase in prices, or, looking at the other side of the coin, depreciation in money. If the depreciation of money is the consequence of a loss of confidence in the credit worthiness of the government, we have hyperinflation. The ultimate hyperinflations result when the existing government is destroyed, making its currency worthless - a 100 percent depreciation. There are, of course, degrees of hyperinflation.

It is a truism that if the flow of money in the market place increases relative to the flow of goods and services offered for sale, prices on the average will rise. Therefore, to say that a cartel or monopoly that posts a higher “administered” price causes inflation has to be premised on the assumption that the monetary authorities respond to such price fixing practices by increasing the volume of money and/or the public responds by increasing the rate of flow (transactions velocity) of money. The same reasoning applies to increases in wages achieved through the monopoly powers of a union. These price increases will result in a transfer of purchasing power and wealth to the groups with dominant economic powers. The resulting price distortions will weaken and depress the economy, increasing unemployment and ultimately creating a deflationary effect.

If the response of the monetary authorities is to provide additional legal reserves to the banking system, resulting in an expansion of bank credit and the money supply, other prices will rise and the monopolistically created prices will be “validated”. This obviously may lead to an “administered” price ---credit money spiral, and we have the core of chronic inflation. If the monetary authorities try to compromise the situation and reduce the rate of inflation, we end up with stagflation. But this is preferable to an all out monetary effort to create full employment irrespective of the inflationary effects. For if the rates of inflation increase, so will interest rates; and high interest rates alone are a sufficient factor to induce a severe recession or even a depression.

In other words, the powers of the Fed are limited. The solution to this problem is to eliminate, or sharply reduce the economic powers of monopolies, oligopolies and any other form of concentration of economic power. How to do this without the creation of an authoritarian state has yet to be discovered.

2007 Jun 17 12:00 PM

[flow5:]

It is a truism to say that inflation is basically a monetary phenomenon. It results from too much money chasing too few goods and services. Since the evidence of inflation is a chronic across-the-board increase in prices, the question to posit is: What were the circumstances, or causes, which resulted in a chronic rate-of-flow of funds in the markets in excess of the volume of goods and services offered?

The uniqueness of this inflation is attributable to the unprecedented reduction in reserve requirements and reservable liabilities of the commercial banks. But it is largely attributable to a sharp growth in the volume of time deposits of commercial banks, and the conversion of time deposits from being simply savings accounts to a means-of-payment role, or its economic equivalent, auxiliary money. In effect, the volume of means-of-payment money rose in excess of one trillion dollars.

These unique, and inflation-causing changes in monetary policy and the structure of the banking system were the consequence of an almost universal misconception of the economics of time deposit banking, and the basic differences between commercial banks and the financial intermediaries.

When the commercial banks make loans to, or buy securities from the non bank public (includes the federal government, state, and other governmental jurisdictions) an equal volume of new demand deposits is created in the economy. Since REG Q ceilings were eliminated, trillions of deposits were diverted into time deposits; not because they were saved, but because of the structural changes in the banking system that made most of these time deposits a type of auxiliary money.

It should be remembered that there is a one-to-one relationship between time and demand deposits. An increase in time deposits depletes demand deposits by the same amount, either directly or via the currency route, and vice versa. The initial growth of the money market mutual funds, for example, had no effect on the volume of demand deposits. Checks that were drawn on MMMF's did not change the volume of money (from the standpoint of the economy), only the velocity of money.

This massive diversion of demand deposits into time deposits was wholeheartedly supported by the bankers, sanctioned by the monetary authorities, and "sanctified" by the Keynesian theories held by virtually all economists.

That the individual bankers should regard their separate institutions as financial intermediaries in the savings-investment process is understandable. No bank can make loans if it does not have a net inflow of funds. These deposits give the bank excess clearing balances, i.e., loanable funds. But how can the banking system have excess clearing balances? That occurs when the Fed pumps legal reserves into the System. When this happens, the System can, and does, create a multiple volume of credit/money.

Professional economists have no such excuse for misinterpreting the savings-investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, and income and expense statement for the System, and a simultaneous analysis for the flow of funds in the entire economy. From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

The process of "monetizing" time deposits began in the early sixties. Citicorp was the first bank to use the negotiable certificate of deposit. Soon, all the major banks were in the act. To this incentive to expand time deposits, the Fed added higher and higher interest rate ceilings on time deposits under their Regulation Q. Today, all interest rate ceilings have been eliminated. Further incentives to time deposit growth were the introduction of ATS accounts, the reduction of reserves ratios against time deposits and eventually their removal altogether. As if this were not enough, the monetary authorities continue to allow the introduction of financial innovations, e.g., money market deposit accounts (MMDA's) which now allow 24 transfers per month, etc. The inevitable consequence of all these structural changes was the runaway velocity for demand deposits.

The inflationary impact of these flows is not revealed by either the producer or consumer price indexes. They reflect, in only a marginal amount, the inflation that has taken place in real estate. Soaring real estate prices have been "validated" by these enormous flows. Rampant speculation and a deluge of irresponsible borrowing and lending have, as a consequence, characterized the industry.

In an accounting sense, the Fed has an unlimited capacity to lend. It operates under no reserve or reserve ratio constraints. Nor does it need to be concerned with a new outflow of funds as a consequence of its lending activities. Advances to borrowers simply involve crediting the borrower's interbank deposit account. These accounts are, however, "high-powered-money" to use Milton Friedman's term. They provide the basis for a multiple expansion of money. Can't the Fed offset these advances with open market sales? Not on a very large scale without destroying the Treasury's capacity to manage the national debt.

Thus far, the Fed has been able to maintain the liquidity credibility of the banks. How long can this necessary degree of confidence be maintained? There is no answer, but it is certain that the crucial test is yet to come.
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2007 Jun 17 12:10 PM

[Katy Delay:]

See comment below.

2007 Jun 17 04:01 PM

[Katy Delay:]

Both Picerno and sbh_home have great points. I would like to get a better grasp of sbh_home's ideas on this subject. Do you have a blog or website?

2007 Jun 17 04:00 PM

[seterk:]

Does anyone know which inflation index is used to figure COLA's for Federal employees?

2007 Jun 17 09:45 PM