Tuesday, February 13, 2018

Solving the Federal Reserve's Inflation Puzzle

Let's open this posting with a graphic from a September 2017 Federal Reserve presentation that shows the history of the year-over-year percentage changes in Personal Consumption Expenditures inflation (PCE inflation):

As you can see, despite the Federal Reserve's very best efforts, they have been unable to keep the inflation rate much above their 2 percent target since the end of the Great Recession.  This seems to be cause for great concern as shown in repeated comments from key Federal Reserve personnel, including current Fed Chair, Janet Yellen:

"...inflation as measured by the price index for personal consumption expenditures (PCE) has generally run below the FOMC's 2 percent longer-run objective since that goal was announced in January 2012.  Core inflation, which strips out volatile food and energy prices, has also fallen persistently short of 2 percent.  Furthermore, both overall and core inflation, after moving up appreciably last year, have slipped again in recent months. Sustained low inflation such as this is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions. In addition, a persistent undershoot of our stated 2 percent goal could undermine the FOMC's credibility, causing inflation expectations to drift and actual inflation and economic activity to become more volatile." (my bold)

While Ms. Yellen clearly states that some of the uncertainty in inflation can be related to oil price drops, the foreign exchange value of the U.S. dollar, slack in the labor market and "...idiosyncratic developments unrelated to broader economic conditions...", whatever that may be, recent research by two economists at the Federal Reserve Bank of San Francisco have a reasonable explanation that may explain at least some of the lack of inflation in the American economy.

The November 2017 FRBSF Economic Letter by Tim Mahedy and Adam Shapiro entitled "What's Down with Inflation" takes a detailed look at the spending categories that make up consumer spending, looking for trends in all categories.  They note that there are two categories of goods and services as follows:

1.) Procyclical categories where inflation has historically exhibited a trend that moves in tandem with the economic cycle (i.e. as the economy expands, prices rise and as the economy contracts, prices decline).

2.) Acyclical categories where inflation has historically exhibited a trend that moves independently from the economy.

Traditionally, economists use the Phillips curve to explain the relationship between prices and the health of the economy using the rate of unemployment.  Here is an example of the Phillips curve for the period from 1961 to 1969:

Economist A. W. H. Phillips, studied wage inflation and unemployment in the United Kingdom for the period between 1961 and 1957 and determined that there was a consistent relationship; when unemployment was high, wages increased slowly and when unemployment was low, wages rose rapidly.  Other economists extended this relationship to general price inflation and unemployment.  While the relationship held true for most of the 20th and early part of the 21st century, the relationship has broken down since the Great Recession; with the present-day U.S. economy basically at full employment, inflation should be much higher than it is currently.

As I noted above, the authors of the FRBSF Economic Letter looked at all of the individual sectors that make up the U.S. economy and then placed each sector into one of two groups; procyclical or acyclical as noted above.  They found the following:

1.) Procyclical categories made up 42 percent of the PCE and include housing, recreational services,  food services and some nondurable goods.

2.) Acyclical categories made up 58 percent of the PCE and include health-care services, financial services, clothing, transportation and a few smaller categories.

From this, the authors were able to create inflation curves for both categories:

As you can see, during part of the period between 1985 and the present, the two inflation series move together, including the period between 2011 and 2013.  After 2013, the two curves diverge markedly with inflation in the acyclical categories dropping to one percent or less as the inflation in the procycliical categories rose or remained roughly steady at between 2 and 3 percent.  While not a unique occurrence over the 30 year-long period, this situation has not occurred since the period between 1996 and 2002 when PCE inflation was between 5 and 9 percent.

Then authors then went on to look at the contribution of each of the two categories to overall core PCE inflation over the period between 2002 and 2017:

Procyclical categories are currently contributing about the same to PCE inflation as they did in 2002 to 2007, however, accylical categories are contributing about 0.6 percentage points less than they were in the early part of the new millennium.  

The authors go on to break down the acyclical sectors of the economy to see which one(s) account for  low inflation.  They found that health-care services, which account for about 35 percent of acyclical inflation and 20 percent of core PCE inflation, are responsible for much of the decline in core PCE inflation as shown here where the deviation from the benchmark inflation rate is marked as a solid black line and the blue bars denote the weighted contribution to the deviation in inflation from the health care sector: 

As well, you should note that in 2017, there has been a substantial contribution to low acyclical inflation from categories that are not related to health care, more specifically, a decline in the prices of cell phone services.

The authors observed the following:

1.) health care services inflation averaged 3.5 percent annually in the mid-2000s

2.) health care services inflation averaged 1.1 percent over the past five years

Why is this?  The authors suggest that the persistent decline in health care services inflation is related to legislated changes in Medicare payments, including the changes mandated by the Affordable Care Act.  According to the Centers for Medicare and Medicaid Services, Medicare payments are set to grow at 2.0 percent in the 2018 fiscal year compared to 0.6 percent in fiscal 2017 and 0.9 percent in fiscal 2016.  This means that the projected increase in Medicare payments could translated into as much as a 0.3 percentage point increase in overall health care services inflation but only a 0.05 percentage point increase in core PCE inflation. 

Health care services are now contributing about 0.3 percentage points less to core PCE than prior to the Great Recession; if health care services inflation was at the levels experienced during the early- and mid-2000s, core PCE inflation would have been above 2 percent for most of the post-Great Recession period, putting inflation within the Federal Reserve's comfort zone.

This interesting analysis may explain at least part of the current low official inflation rate (your personal experience may vary!).  In any case, given central bankers abhorrence for deflation, the Federal Reserve's concerns over the current stubbornly low inflation environment is warranted.  With consumer expenditures accounting for nearly 69 percent of the U.S. economy as shown here:

...any deflationary pressures that exist will result in consumers postponing spending since they expect that prices for those all important consumer goods will be cheaper in the future and, according to central bankers, that is a bad, bad thing!


  1. great post--I remember finding this to be a particularly good article from the boys at the SF Fed. Highlights what is going on beneath the surface in inflation--and how it could go materially higher owing to reversals in acyclical categories, not (necessarily) driven by growth, full employment, etc.

  2. In the last 30 years, a growing gap has become obvious between government reporting of inflation, as measured by the consumer price index (CPI), and the perceptions of actual inflation held by the general public. The numbers government pumps out today are the result of changes made in the 1990s when political Washington moved to change the nature of the CPI.

    The cuts in reported inflation were an effort to reduce the federal deficit without anyone in Congress having to do the politically impossible which was to register a vote that would harm the image of Social Security. I further contend that inflation would be much greater if more money was flowing into tangible goods rather than paper investments and promises. For proof as to the real cost of inflation just look at the surging replacement cost resulting from recent storms and natural disasters.