President Biden, congressional Democrats and Fed watchers celebrated as the Consumer Price Index suddenly stabilized from June to July. In other words, month-to-month headline inflation, which includes food and energy prices, was zero percent. Core inflation, which omits these volatile prices, was a modest 0.3%. Although headline inflation was expected to be lower in July because of falling energy prices, both the headline and core numbers were lower than expected, giving welcome relief to consumers who have felt the sting of rapidly rising prices for more than a year.
Is this week’s report an indication that the inflation surge has finally peaked? While it is an encouraging sign, there are several reasons we should be careful not to assume we’re in the home stretch of the fight against rising prices.
First, let’s look at the details of the report. The best news is that energy prices—most importantly gasoline—fell steeply. Some other prices are also either falling or increasing at a slower rate. For example, the prices of used cars and trucks, which skyrocketed last year, fell between June and July. Apparel is another category that experienced price decreases. Prices of manufactured goods, especially durable goods such as cars, tend to fall over time because of productivity improvements in those sectors. The recent relief in these categories could suggest that they are finally reverting to their previous trends.
Despite this good news, two other important sectors, food and shelter, saw price increases. Because these are largely unavoidable expenses, consumers are still encountering rising prices. The COVID-19 pandemic, the Russia-Ukraine war and higher energy costs are all factors contributing to more expensive food. Hopefully, these pressures will subside as energy prices fall and companies continue to adapt to the pandemic. Russia’s recent agreement with Ukraine, resuming the export of Ukrainian grain (assuming Russia honors this deal), will also help. Changes in rent tend to lag behind changes in other prices, so it’s possible that we’ll see rents continue to rise for some time.
Second, while the CPI is the most cited price index in popular media, the Federal Reserve, the agency responsible for price stability, targets inflation as measured by the Personal Consumption Expenditures (PCE) Price Index. The CPI and PCE behave similarly, but the Fed uses the latter because it better reflects changes in consumers’ spending habits. For example, if beef becomes more expensive relative to chicken, consumers may buy more chicken and less beef. This substitution would be taken into account in calculating the PCE but not the CPI. As with CPI inflation, there is both headline and the less volatile core PCE inflation, which the Fed values because core PCE is a better indicator of where the headline number will go in the future. It’s reasonable to be cautiously optimistic that this preferred index will also show some inflation relief, but we won’t know for sure until the Bureau of Economic Analysis publishes the July PCE on Aug. 26.
Third, although month-to-month inflation has fallen, anyone who has not been living under a rock knows that prices are significantly higher now than they were a year ago. The entire CPI is up 8.5% from a year ago, while core CPI is up 7%. As of June, headline and core PCE were up 6.8% and 4.8%, respectively, from a year ago. The Fed tries to target 2% annual headline PCE inflation on average, and 6.8% is still a long way from that goal.
Fourth and most importantly, while supply-side factors such as the pandemic or the Ukraine war can cause temporary changes to the price level, excess demand in the economy is what causes persistent inflation. Economists generally use total dollars of spending, or nominal GDP, as a measure of aggregate demand. Before the pandemic, nominal GDP growth was around 4% on average (with 2% coming from inflation and another 2% coming from output or real GDP growth). Nominal GDP fell sharply in 2020 but then sharply rose the following year and even exceeded its pre-pandemic trend. To get inflation under control, the Fed needs to get nominal GDP growth back to trend.
Unlike monthly inflation data, nominal and real GDP data only come out quarterly. Last month, the Bureau of Economic Analysis published the GDP for the second quarter of 2022, and the data were not very encouraging. While real GDP growth shrank, quarter-to-quarter nominal growth rose from 1.6% to 1.9%, and the level of nominal GDP was 9.3% higher than a year ago. The nominal GDP gap, a metric produced by the Mercatus Center at George Mason University that compares actual nominal GDP to a “neutral” measure based on previous forecasts, also rose, indicating that monetary policy is still too loose.
It’s reasonable to hope that nominal GDP growth will be slower in the third quarter than in the second, given falling prices, more recent Fed interest rate hikes and a cooling economy, but 9.3% is still well above the normal 4%. We won’t know for several more months whether the Fed has succeeded in slowing spending back down to a much lower trendline.
The CPI report offers a glimmer of hope that the worst may be behind us, but there is still a long road ahead. We should remember that while the Fed can’t be blamed for rising oil and food prices due to a pandemic and a war, it likewise deserves no credit as those price shocks ease. We’ll know we’re making real progress against inflation once nominal GDP growth and core inflation fall to rates more consistent with the pre-pandemic economy.