EconSouth (Third Quarter 2004)

Andrew Bauer (left) and Nicholas Haltom are senior economic analysts in the macropolicy section of the Atlanta Fed’s research department.


Regarding the
Components of Inflation


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 inflation’s 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
Let’s 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. What’s 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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