The CPI Food and Energy Debate

Occasionally I see something that annoys me so much that I feel the need to respond to it in a blog post.  Today, it was that I saw people on a message board saying that the Consumer Price Index (CPI) no longer includes food and energy so you shouldn't pay attention to it.  There are some legitimate criticisms of how CPI is calculated, but this isn't one of them.  The headline CPI number does include food and energy, but economists are usually more interested in the so-called "core" CPI rate, or the change in prices excluding food and energy.  The reason that they prefer this measure is that it isn't as driven by possibly arbitrary changes in commodity prices.  If inflation is truly endemic, it will show up in less volatile prices because wages are likely also inflating at a rapid rate, pushing up the prices of more stable goods as well as services.

Some have also wondered if over time the two come out more or less the same.  After all, according to some, inflation and food and energy is always faster than other prices so if you follow core inflation only you are missing the story.  Well, not really:

For most of the years after 1981, core CPI actually outpaced total CPI because energy and food prices were quite sedate while health care costs went through the roof.  Since the mid 1990s, however, it is true that total CPI has outpaced core inflation.  In fact, the compounded annual growth rate (CAGR) of total CPI vs core CPI has been 0.5% a year higher than core inflation since September 2000.  Still, what history would suggest is that these two will not diverge by a great deal for that long.

Now, as to the volatility, adding food and energy does add a great deal of volatility.  The average monthly inflation rate of both measures over the past 54 years is about 0.32%, but the standard deviation for the total CPI is a full 0.06% higher than for the core CPI.  It might not sound like a lot, but it does matter.

So no, there isn't some evil conspiracy behind excluding food and energy.  In truth, I look at both anyway as alternative measurements.  It doesn't take too long and there isn't much harm in doing it.

Economic Data Summary: Week Ending May 21st, 2010

The data released in the past week were mixed, the first week in a while where that was true, however there does not seem to be much of a change in the overall trend of steady, moderate economic growth.

April Consumer Price Index (CPI)

This is the measure of prices paid by consumers for a pre-determined basket of market goods. Along with the PCE deflator, it is one of the two primary methods for determining the rate of inflation for consumers.

In April, the headline number fell 0.1% and is up 2.2% year on year. The April decline was driven by lower energy prices and that trend will probably continue for a couple more months with the recent decline in crude oil prices as well as gasoline and natural gas prices. The core rate, less food and energy, was flat for the month and is up 0.9% year on year. Inflation is very modest and there are few signs that it will accelerate soon in any meaningful way.

April Producer Price Index (PPI)

This is essentially the CPI for businesses, focusing on manufacturers in particular. There's really not much more to say about it except to say that, along with the CPI, these releases can move markets when there are concerns about Federal Reserve interest rate moves. This is because when markets are on edge fearing rate hikes, strong inflation numbers will change interest rate expectations to the upside and hurt equity and bond prices.

Like the CPI, the headline number was down 0.1% month on month, driven by energy. Year on year, the finished goods index was up 5.5%, which would look scary under most circumstances. However, as recently as July of last year the PPI was down 6.9% year on year so the comparisons are somewhat skewed. PPI is subject to much more wild swings than CPI because changes in raw materials prices are felt more rapidly and are not moderated by the fact that not all price increases are passed on to consumers.

April Housing Starts