The topic of rising inflation has crept back into many Americans
minds recently. Rising prices for milk, steel, and gasoline—among
other items—have fueled many articles in the press. These price
developments have contributed to a considerable shift in the inflation
outlook. As recently as last year, deflation—generally defined as
a broad-based decline in prices often associated with weakening aggregate
demand—was seen by some as a possibility.
By the end of 2003, core consumer inflation rates, or inflation rates
excluding volatile food and energy components, had declined to their lowest
levels since the early 1960s. By contrast, commentary during the past
several months has dwelt on the prospects of accelerating inflation as
core inflation rates turned sharply upward in the early part of this year.
The devil is in the details
As core consumer inflation rates moved lower in 2003 and higher earlier
this year, an increasing and probably undue amount of attention was placed
on each monthly aggregate inflation number in news headlines. The aggregate
inflation rate is limited in the information it provides, especially with
regard to the sources of its movements. It is generally difficult to know
whether changes in aggregate inflation result from broad-based price changes
or from significant and perhaps idiosyncratic price changes in only a
few goods or services.
Analysts often attempt to confront this issue by examining price changes
of major inflation components and then making inferences about the impact
of those changes on the aggregate inflation rate. However, such inferences
are imprecise. A more rigorous approach is to provide a precise decomposition
of the inflation rate by calculating percentage point contributions of
components to the aggregate, a technique commonly used to analyze U.S.
gross domestic product (GDP).
By highlighting the composition of aggregate inflation, we gain greater
insight into the underlying trends in inflation and can make more informed
inferences about inflations near-term direction. This method
is particularly important because it allows analysts to distinguish broad-based
changes in inflation from changes due to movements of only a few components.
Accounting for recent inflation movements
Lets reconsider all the talk about deflation in 2003. Analysis shows
that from November 2001 (when core inflation peaked at 2.8 percent as
measured by the consumer price index, or CPI) to December 2003, two main
CPI components—residential rent and used vehicle prices—drove
the decline in CPI core inflation. The combined contribution of rent and
used vehicles to CPI core inflation dropped by 1.1 percentage points and
accounted for a considerable portion of the 1.6 percentage point decline
in the core CPI. Whats more, these price changes did not reflect
a fundamental weakening in housing and vehicle demand but instead showed
the dynamic effects of interest rates on consumer demand for homeownership
and new vehicles. Downward pressure on rental prices mainly resulted from
an increase in demand for owning homes, which was spurred by historically
low mortgage interest rates. The price declines of used vehicles largely
reflected increasing demand for new vehicles in response to rebates and
record-low financing. This deeper look at the inflation data suggests
that the concern and discussion regarding overall price deflation were
perhaps overstated.
Looking forward
In the first half of 2004 there was a great deal of commentary and concern
when core inflation rates rose sharply. CPI core inflation rose from its
low of 1.1 percent in December 2003 to 1.8 percent in April—to some
a startling increase in just four months. Does this sharp increase indicate
that inflation is roaring back? A look at the sources of the increase
shows that isolated, distinct movements in a few components were responsible.
Prices of apparel and nonhome lodging, such as hotels and motels, accounted
for more than half of the increase. Since April, the dramatic increases
in those components have moderated, and the overall core inflation rate
has stabilized. Though prices of some goods and services other than hotels
and clothing have risen slightly, there is little indication that persistent
inflation will rear its ugly head in the near future.
Of course, simply looking at the details underlying the headline inflation
numbers by no means gives a perfect understanding of inflation. Inflation
is a notoriously difficult economic variable to forecast. Still, by looking
at the contributions to inflation by specific components, we can gain
a better understanding of movements in aggregate inflation rates as well
as make more informed inferences about future inflation.
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