Inflation: Nothing to See Here?

Actually, prices may already be rising at an 8 percent annual rate

On June 10, the government released its report on the Consumer Price Index (CPI) for May of 2021. These numbers can be sliced and diced in many ways. I am going to show you one reasonable way to look at the figures, and this indicates an annual inflation rate of 8 percent. This is the highest since the summer of 1982. That is thirty-nine years ago, perhaps even before you were born.

How should one measure the annual rate of inflation? When I was younger, the media reported the annualized one-month rate of inflation. If the CPI went up by 1 percent from one month to the next, reporters would multiply by 12 to get a 12 percent annualized rate of inflation. In fact, because of compounding, the true annualized rate would be even higher, about 12.7 percent.

For May of 2021, the government reported a one-month increase of 0.6 percent. Multiplying by 12 gives 7.2 percent as the annualized rate of inflation. But I have not seen any news media reporting this number.

Most media instead report the rate of inflation from May 2020 to May of 2021, which is 5 percent. That is called “year-over-year” inflation, and it is another measure of annualized inflation. Most news stories are quick to point out that May 2020 consumer prices were “depressed,” which they suggest artificially makes the jump to May of 2021 large.

But if the year-over-year inflation rate of 5 percent is biased upward, why not use the monthly annualized rate of inflation instead? The monthly annualized rate of inflation does not suffer from “base bias.” But the monthly annualized rate of inflation of 7.2 percent is even higher than the “biased upward” year-over-year rate.

In terms of arithmetic, the “base bias” story is wrong. It turns out that the year-over-year inflation rate is being held down by data from the pandemic, which exerted an influence most of the latter part of 2020, not just May. Looking at inflation year over year gives a picture that is artificially low, not artificially high.

Special Factors

One argument against relying on a monthly inflation rate is that it is affected by special factors. For many years, sophisticated analysts have looked at the “core CPI,” which excludes food and energy, two categories where prices bounce around a lot from month to month. Looking at the core CPI removes transitory blips that have taken place over recent decades.

But food and energy were not the drivers of the recent run-up in the CPI. In contrast to past transitory upticks in inflation, in April and May the core CPI increased by more than the overall CPI. The food and energy sectors actually exerted a slight moderating influence.

If we take March, April, and May together, the core CPI rose by 2 percent over this period. Multiplying by 4 to get an annual rate gives 8 percent. This could very well be the most reasonable estimate of the current rate of inflation.

This annualized three-month increase in the CPI of 8 percent is a dramatic breakout. The last time we saw a number that high was July of 1982.

The 8 percent three-month annualized core inflation is more than double anything that we have seen for almost the entire period of the last 25 years. The three-month annualized core inflation rate was below 4 percent for the entire period from April of 1995 through July of 2020. Last August and September saw three-month core CPI increases of 1.14 percent and 1.08 percent, but this uptick was followed by a sharp drop-off.

What about special factors other than food and energy? It is true that used car prices will not continue to rise as rapidly as they have recently. But on the other hand, the CPI is very slow to pick up on the increased cost of housing, which is evident to anyone tracking the residential real estate market. Double-digit increases in home prices have yet to be reflected in the CPI, but they almost surely will show up eventually.

Inflation has never been easy to measure, and it is particularly difficult today. (See Is the Economy Illegible?) Some industries are booming, and some are depressed. More and more economic activity takes place in hard-to-quantify sectors, such as health care and education, where the challenge is to divide spending totals between increases in real output on the one hand and increases in prices on the other.

But for this purpose, I am just looking at the CPI as reported by the government statisticians. If you rely on media reports, you are not getting the real story told by these numbers. Reporters are claiming that inflation is only 5 percent, and they add that even this number is overstated. Nothing to see here, move along.

I am looking at the same numbers but taking a three-month average multiplied by 4, and using the core CPI. Such a calculation informs me that inflation is actually 8 percent.