Markets React to Inflation SurpriseLearn more about this firm
Yesterday’s inflation print was a big surprise—a bad one. Yet, looking at the headlines, you could be forgiven for wondering why. The headline CPI, after all, increased by only 0.1 percent, after being flat the prior month. If we annualize those two months, the inflation rate would be only 0.6 percent per year, which is the opposite of what everyone is panicking about. It isn’t that simple, of course. But given that and the fact that inflation for the past 12 months was down from 8.5 percent to 8.3 percent, it would seem inflation is slowing. So, why the panic?
Core Vs. Headline Inflation
The answer is that overall inflation remains high and may be accelerating, despite the headline number. The reason that number was so low is that gas prices dropped sharply, even as other prices continued to rise. The core CPI number, which is a better indicator of general price changes and excludes energy and food, was up sharply by 0.6 percent. This result was double both expectations and the prior month’s number, while the past 12-month number rose from 5.9 percent to 6.3 percent. Not only is core inflation up, but it is accelerating. That is a real problem.
Just why that is relates to the reason we differentiate between headline and core inflation. Headline inflation reflects the costs people incur in their real lives, which include heating, driving, and eating. As it reflects people’s lives, it makes sense that it is the headline number. The problem? From a monetary management perspective, it is not a good indicator of inflation. Two items in particular, energy and food, are not optional purchases. You have to eat, and you have to drive. Demand tends to hold despite changes in economic conditions.
Because demand for these tends to hold, prices depend on supply, rather than general economic conditions. Gas prices depend on oil prices, which depend on oil production. Food prices depend on, well, food prices, which depend on food production. Changes in prices in these two items are independent of (and not good indicators for) price changes in the rest of the economy. That is why we take out food and energy to get core prices, which are a better indicator of price changes due to the economy.