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Inflation’s sticky situation

| November 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

There are a million and one different ways to parse the inflation data.  Headline inflation, core inflation, trimmed mean and the list goes on. The tea leaves of inflation also fall into categories based on how often a particular item changes price.  It turns out that categories with relatively infrequent changes tend to offer embedded information about inflation expectations and, in turn, provide some predictive power for broad inflation.

Flexible and sticky prices

Academic economics have delved deeply into the CPI data to see how often prices actually change for all of the categories.  According to one highly detailed study, the average line item changed prices once every 4.3 months.  Some categories saw prices chang quite frequently, such as gasoline.  Other goods and services go long stretches between price changes. For example, the study found that coin-operated laundries changed prices only about once every 6.5 years.

Economists at the Atlanta and Cleveland Fed banks have developed a systematic approach for looking at prices using this filter.  Any category that registers price changes more frequently than average are considered flexible-price items and those for which prices change less frequently than average are considered sticky-price items.

Aggregating the two groups, Cleveland Fed economists found that flexible-price items, which account for roughly 98% of month-to-month volatility in the CPI, tend to be more correlated than sticky-price items with economic conditions such as labor market slack.  For many sticky-price items, the costs of changing prices are substantial.  Consider a soda machine.  If the machine charges 50 cents for a soda and canned soda prices increase by 2%, vendors are not going to change the machine’s price to 51 cents.  Rather, vendors will wait until there has been a substantial price hike and then raise the price, perhaps to 75 cents.  In contrast, gasoline stations can change their prices virtually daily, with little nuisance, as pumps can be reprogrammed quite easily.

Since sticky-price items tend to see infrequent changes, the price setters for these items will take into account not only what has occurred in the past but also some sense of inflation expectations.  For example, if there is a broad expectation that soda prices are likely to increase substantially, then the vendor might bump up the machine’s charge to 75 cents, even if the actual cost of a can of soda has only moved from 50 cents to 60 cents.  In contrast, if soda prices are expected to remain steady for a long time, vendors may not go to the trouble of adjusting prices in their machines.

This insight suggests that a sticky-price aggregate might offer some value for predicting inflation, since it has embedded information on inflation expectations.  Cleveland Fed economists found that the sticky price index did a better job than the overall CPI at forecasting inflation, and the marginal predictive benefit got bigger as the time horizon extended further into the future.

Based on this insight, Atlanta Fed economists have calculated and continue to update various flexible-price and sticky-price CPI indices as a supplement to the more popular aggregates.  The latest 12-month change for the flexible-price and sticky-price aggregates are shown here.

Exhibit 1: 12-Month Change in flexible-price and sticky-price CPI

Source: Federal Reserve Bank of Atlanta

The flexible-price gauge (the darker line) has cooled substantially over the past year, though the bulk of the moderation reflects the drop in energy prices.  The core ex-food and energy flexible price gauge has risen by 1.1% over the past 12 months, matching the highest reading since 2013 (Exhibit 2).

Exhibit 2: 12-month change in core flexible-price CPI

Source: Federal Reserve Bank of Atlanta

More importantly, the sticky-price CPI has crept higher over the course of 2019, reaching 2.7% in August and September, which matches the highest reading in over a decade.  While the movement has not been especially large, the Atlanta Fed sticky-price gauge suggests that the underlying inflation trend may be inching up, consistent with my view that the Fed will finally see the core PCE deflator measure—and probably the headline index as well—move decisively above its 2% target in 2020.  Indeed, this finding should not be particularly surprising, as virtually every major indicator of underlying inflation other than the core PCE deflator is sitting at multi-year highs.

For what it’s worth, the sticky-price framework for parsing the CPI is a more formalized version of how I have broken down and discussed the core CPI for years, pulling out what I have called the Fearsome Five (apparel, new and used motor vehicles, hotel rates, and airfares), the five most volatile and noisy line items within the core, and looking at that grouping and the ex-Fearsome Five to get a sense of whether fluctuations in the core CPI are being driven by one or two anomalies or reflect more persistent movements.  Similar to the sticky-price CPI, the core CPI ex-Fearsome Five shows a modest acceleration in recent month, which could be noise but may also be telling us something about the underlying path of price hikes.

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