July consumer prices reflected continued low inflation, confounding consensus and Fed expectations. Both the headline Consumer Price Index (CPI) and Core CPI (excluding food and energy) showed 0.1% increases in July and 1.7% increases over the past 12 months. The Fed’s inflation target actually concerns the core price deflator for personal consumption expenditures. Based on today’s news, that indicator is also likely to show a 0.1% gain for July, but only 1.4% for the last 12 months, well below the Fed’s (unofficial) target of 2.0%.
Yes, these core inflation measures exclude food and energy, but not much is happening there, as is suggested by the headline CPI. Food prices rose 0.2% in July and 1.1% over the last 12 months. Energy prices declined 1.0% in July and are up 3.4% over the past 12 months, but down 8.0% over the last seven months.
It is the short-term volatility in food and energy prices that causes them to be excluded from core inflation, not any tendency for them to rise (or fall) especially sharply. Energy prices have indeed been volatile over recent years, but this volatility has averaged out over the last year or so, and underlying inflation rates for both headline and core inflation tell the same story.
Continued low inflation has frustrated the Fed’s intentions, but it has been no surprise to us or to anyone that takes a comprehensive approach to inflation, rather than the Phillips Curve take promoted by the Fed and many Wall Street commentators. The Fed view seems to be that inflation erupts, as if by magic, any time the unemployment rate drops below a certain level.
Our view is that inflation occurs when monetary policy has driven excess growth in spending across the economy. Yes, that excessive spending serves to push unemployment unsustainably low, but it also manifests itself, again, across the entire economy, generating noticeable acceleration in total spending growth. Unless it is excessive spending growth that is driving lower unemployment, there is no reason to think that unemployment rates provide meaningful information with regard to inflation.
The best measure of spending growth is nominal GDP. In the present expansion, growth in nominal GDP has held extremely steady, in a 3% to 4% growth channel. This is not fast enough to generate both decent economic growth and higher inflation than what we have been seeing. And with the last Fed stimulus almost three years in the past and present policy set on tightening, there is no reason to expect accelerating spending growth in the foreseeable future. We believe inflation will continue to hold below Fed targets.