The Big Idea

The breadth of inflation

| March 10, 2023

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.

Most analysis of consumer price inflation focuses on the magnitude of increases.  But the distribution of inflation across different parts of the index also shines important light on the outlook for prices.  Work on the breadth of inflation from the Dallas Fed indicates that high inflation remains quite broad, suggesting that the FOMC is not yet making much progress in bringing price hikes under control.

Dallas Fed analysis

The Dallas Fed offers an alternative inflation series called the trimmed mean PCE deflator.  In brief, economists at the Dallas Fed rank each of the 178 major line items in the PCE deflator from highest to lowest inflation rates.  Then, in an effort to isolate the underlying trend of inflation, they strip out the outliers at the top and bottom of that ranking. The Dallas Fed determined that the best formula for correlating the trimmed mean with the trend in the headline PCE deflator over time is to lop off the lowest 24% of the index by expenditure weight and the top 31%.

In any case, ranking the line items to calculate the trimmed-mean index also yields interesting data on the breadth of inflation. The Dallas Fed publishes a picture of the proportion of the overall index—each line items scaled by its expenditure weight in the index—experiencing 12-month price increases in various inflation ranges (Exhibit 1).  The picture shows the proportion of the index showing inflation between 0% to 2%, 2% to 3%, 3% to 5%, 5% to 10% and over 10%. The balance of the index between the top stripe and 100% in the chart represents the proportion of the index registering negative readings.  The chart spans from the beginning of 2022 through January of this year.

Exhibit 1: Evolution of the distribution of component price increases

Source: Dallas Fed

Tracking the buckets

We can aggregate the six Dallas Fed buckets, including the implicit negative component, into three larger groups: items with relatively tame inflation, defined as 3% or under, those with high inflation, defined as 3% to 10%, and those with extreme inflation of more than 10%.  The evolution of these three groups at three points in time offers some insight into underlying inflation dynamics: January 2022, the month that year-over-year PCE inflation peaked in June 2022 and the latest reading for January 2023 (Exhibit 2).

Exhibit 2: PCE Deflator Buckets

Source: Dallas Fed.

There are a few key takeaways.  First, the proportion of the index in the “tame” category has not varied much from January 2022 to June to the latest reading, always near 30%.  This finding, in and of itself, has to be quite troublesome for the Fed.  If the goal is to hit a 2% target, then ideally the bulk of the major components in the overall index should be running close to that target.  It is conceivable in theory to achieve 2% overall inflation with a chunk of the index running sharply negative and a similar sized piece running at very high inflation rates, but this is clearly a suboptimal path to price stability.  It would yield vastly different inflation outcomes for various households in addition to offering a much less predictable and stable path to hitting the 2% target.

Second, there has been some decline in the “extreme” category since the peak of inflation in June.  This makes sense, as over the past seven months, many of the line items that were most affected by supply chain issues should have seen a cooling of inflation.  In addition, most of the energy sector was likely in the “extreme” bucket in June and has since moved down.

In isolation, the decline in the “extreme” bucket is a sign of progress.  However, the troublesome fact for the Fed is that it appears that most of the line items that moved out of the “extreme” bucket since June have merely shifted down into the “high” bucket.  In fact, since June, the proportion of the index recording 12-month inflation rates between 3% and 10% jumped from about one-third of the index to nearly half.

The bottom line is that the proportion of the PCE deflator index recording 12-month inflation of more than 3% actually increased from June to January, from 70% to 72%, even as the 12-month change in the headline PCE deflator cooled from 7.0% to 5.4%.

This alarming breadth of high inflation across the bulk of consumer expenditure categories signals that the Fed has made significantly less progress in taming underlying inflation since last summer’s peak in year-over-year inflation than the headline figures suggest.  As long as the vast majority of spending line items are experiencing inflation far above the 2% target, it will be difficult for the Fed to sustainably achieve its goal.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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