One of these days the professional economists who forecast inflation will stop underestimating the pace of price increases. That day was not today.
The Bureau of Labor Statistics reported on Thursday that the Consumer Price Index (CPI) rose four-tenths of a percentage point in September compared with August. This is twice the rate expected, according to Econoday’s survey of forecasters. Core prices were up 0.6 percent, two-tenths of a point higher than the consensus forecast.
By our count, CPI has now “beat” expectations to the upside in 12 of the last 19 reports. It has only come in below expectations twice. In Wednesday’s Breitbart Business Digest we explored some of the likely causes of this persistent error. In summary, there’s too much herd-following in economic forecasting, decades of low inflation have created the expectation that we’ll quickly revert to price stability, and too many forecasters believe in the twin notions that expectations control and predict inflation and that the Phillips Curve is flat.
If expectations are not the critical metric for future inflation, what is? We have noticed that a lot of talk from family and friends about needing higher wages—or quitting to get a better paying job—is not rooted in a prediction about inflation one, three, or five years from now. Instead, it is rooted in the idea that the cost of living has already gone up. Businesses seeking to attract new workers and retain the ones they have preemptively raise wages. The same is true when businesses talk about raising prices. When a chief financial officer on an earnings call talks about raising prices, he typically describes this as a reaction to higher costs rather than as a calculation based on a forecast of future inflation. In other words, it’s not the expectation of inflation but the experience of it that influences future wages and prices.
Fed economist Jeremy B. Rudd put this more formally in a 27-page paper published this year under the title “Why Do We Think Inflation Expectations Matter for Inflation? (And Should We?).” Rudd’s answer is that people have come around to the view that expectations matter for the same reason that primitive peoples tend to think lightning is the work of the gods: we can tell something important is happening and no other story adequately explains why. His paper quotes economist John Kenneth Galbraith as saying, “It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought.”
Rudd’s answer is a pretty close match to what our conversations with our friends reveal. He says that prices and wages are developed from conditions in the recent past. As he puts it:
In situations where inflation is relatively low on average, it also seems likely that there will be less of a concern on workers’ part about changes in the cost of living—that is, a smaller proportion of quits will reflect workers’ attempts to offset higher consumer prices by finding a better-paying job. But this is a story about outcomes, not expectations: Workers don’t behave this way because they expect to see low inflation in the future, but rather because they don’t view their recent wage increases as appreciably lagging actual changes in the cost of living.
This insight is part of what led us to develop the concept of foodcore inflation. Empirical studies have shown that grocery prices have an outsized effect on the public’s perception of inflation, which means that “core inflation” measures that leave out food prices may be encouraging analysts to underestimate future inflation. What’s more, food prices are now far more stable and closer to general price changes than they were when economists started excluding them from the core back in the 1970s. Foodcore inflation is simply core inflation plus food prices added back in—or, if you wish, all items minus energy.
The most recent CPI print showed that foodcore inflation was up 7.3 percent compared with a year ago, the highest since 1982. For the month, foodcore was up 0.6 percent. This indicates that consumers are experiencing a very high level of inflation that is likely to be salient in their decisions around seeking raises and finding better paying jobs.
Another measure we think is helpful for predicting inflation is the Cleveland Fed’s median CPI calculation, which we consider a measure of underlying inflationary pressures. This rose to seven percent year-over-year, up from 6.7 percent in August and the highest rate ever recorded in records that go back to 1984. The month-t0-month figure remained at 0.7 percent.
Harvard economist Jason Furman said on Thursday that the rate of median CPI growth is the “single biggest threat” to his overall prediction that core CPI will fall to something closer to 4.5 percent.
A similar story played out in the Cleveland Fed’s 16% Trimmed Mean inflation metric. It held onto last month’s 0.6 percent monthly gain and ticked up a tenth of a point to 7.3 percent year-over-year. That is also a record high.
Last month, we noted that some of the disinflationary factors that had pushed inflation lower over the summer had faded. Instead of peak inflation, we had likely seen peak disinflation. The second monthly increase in month-to-month inflation, the sharp acceleration of core inflation, high foodcore inflation, and high median inflation all support this thesis.
So what does this mean for inflation going forward? These figures suggest that inflation is not going to come down very fast in the near term and may continue to accelerate. Some technical factors—such as the way health insurance and shelter prices are calculated and fed into CPI—may somewhat offset the still strong underlying pressures.