Is US Inflation Normal? You Decide.

Consumer Price Index (CPI) inflation ticked up in October, inching from 2.4% y/y to 2.6% as rents, used car and car insurance prices offset continued goods deflation.^[i] Robbed of an upcoming election through which to interpret the data, headlines turned to another familiar trope, arguing inflation clearly isn’t yet back to normal and the Fed must tread lightly with rate cuts. Yet if you compare this report to CPI’s very long history, inflation looks stunningly normal—probably a big reason markets have long since moved on. It is high time, in our view, pundits’ narratives did the same.

The thesis inflation remains abnormally jumpy seemingly rests on two factors. One, the inflation rate rose year over year. And two, the Fed’s target rate is 2.0% y/y. But the inflation rate has wiggled around through CPI’s entire history, which stretches way back to 1913 (making 1914 the starting point for year-over-year data). As Exhibit 1 shows, while the biggest peaks and valleys loom large in memory, the inflation rate is all over the place even during more benign stretches. And neither the wiggles up nor the wiggles down are inherently predictive of big shifts.

Exhibit 1: A Very Long Look at US Inflation

Source: St. Louis Fed, as of 11/13/2024. Year-over-year percent change in CPI (not seasonally adjusted), January 1914 – November 2024.

As for the Fed’s target, using that as a signpost for “normal” seems suspect. One, it is arbitrary. Two, it has been official since only 2012. Three, the target is for the inflation rate to average 2.0% over time, which could frankly mean anything—and a 2.6% rate could easily be part of a long-term average of 2.0%. And four, the targeted rate is based on an entirely different inflation measure: the Bureau of Economic Analysis’s Personal Consumption Expenditures (PCE) price index. The CPI basket comes from a household survey. The PCE basket comes from a business survey. They weight goods and services differently. CPI narrows to urban consumers’ purchases. PCE incorporates all goods bought by or on behalf of all consumers, even rural ones, including purchasers such as Medicare and employer-provided insurance. These may seem technical and academic, but they underscore that CPI and PCE are two different things, so using the Fed’s target for one as a judgment of the other is just weird.

Anyway, “normal” is an opinion, and you are welcome to choose the parameters you would like. We think statistics help. You could use the average inflation rate, if you like, as a guide. The simple arithmetic mean—which you might know as the plain old “average” —of all CPI inflation rates since 1914 is 3.3%.^[ii] Or, you could use the geometric mean, which is the annualized inflation rate—the average rate at which prices compounded over time. That happens to be a tad lower, 3.2%.^[iii] In both cases, October’s rate is below-average.

But we don’t think this is such a great way to do it, because averages are made up of extremes. Just as the S&P 500’s average annualized return of around 10% isn’t its normal annual return, the average inflation rate isn’t the typical inflation rate. You could get closer to typical by looking at the mode (the most frequent occurrence), which is 3.0%, but in a dataset so varied that tends to be meaningless, too.^[iv]

Thankfully, there is also the median, which is the point where there are an equal number of results above and below. We like this better than average because it isn’t as skewed by outlying results. The median CPI inflation rate is 2.7%. That is nearly bang-on October’s inflation rate, which would make October’s rate statistically pretty … normal?

There is a larger fallacy at work, too: the notion that the Fed can fine-tune the inflation rate with small interest rate tweaks. Theoretically, Fed rates influence the speed with which money flows through the economy at a lag, with lending being the main force driving that flow. Fed rates aim primarily to affect banks’ funding costs. Raising or lowering those would—theoretically—reduce or widen the gap between costs and loan rates (revenues), which translates to shrinking or raising profits on new loans. Bigger profits generally make banks more willing to take risks and lend to a wider swath of borrowers.

The theory here is all grand, and it is why the yield curve has such a strong history as a leading economic indicator. But it works less well when banks’ funding costs are divorced from Fed rates, which they have been for years thanks to a massive savings glut. With so much liquidity sloshing around, banks don’t need to pay more to attract deposits. So their costs stayed low while loan rates rose with long rates, and on a nominal basis, US lending didn’t contract during Fed rate hikes. In our view, this makes it tough to find real-world evidence that rate hikes did much to tame inflation. We see a better argument that the economy (and supply) simply grew enough to absorb all the excess money created during COVID.

Or, to view this differently, consider the items elevating CPI. “Rent of primary shelter” is well known to lag new leases, which have moderated a great deal. Owner’s equivalent rent—the amount a homeowner would pay to rent their own home—has a lot to do with mortgage rates, which tie to long rates, which often defy Fed moves. Used car prices are up because car prices in general have been a pain in the neck for years, tied mostly to supply issues and regulatory quirks that discourage companies from selling economical models on our shores. This drove demand for “cheaper” used cars. The latter also affects car insurance prices, which reflect higher maintenance and vehicle replacement costs.

The Fed can’t do anything about this with short-term interest rates. Keeping rates higher for longer won’t suddenly inspire some car companies to stop subsidizing loss-making electric vehicles with higher-priced “luxury” internal combustion models. Nor will they suddenly bring cheaper compact or midsized pickup trucks back to the American market (friends overseas, we are jealous of your compact truck selection). The economy is just too diverse, complex and dynamic for the Fed to be able to pull an interest-rate lever to control prices.

Anyway, we think this all points to why, while headlines continue making CPI wiggles a thing, markets have long since let them fade into the scenery. Stocks know, even if investors don’t consciously think about it, that a 2.6% (or whatever) inflation rate has minimal bearing on how earnings and revenues shape up relative to expectations over the next 3 – 30 months. We have nearly 110 years’ worth of inflation history to prove it. It isn’t an extreme rate. It is the kind of normal rate modelers use to inform long-term straight-line projections.

Inflation was a big deal to sentiment, and therefore stocks, when it was at an extreme two years ago. We get that the scars are still a bit fresh, and we don’t dismiss that. Nor do we dismiss the painful fact that while the inflation rate has cooled, price levels remain high. We feel it when we buy groceries, just like you. But stocks are cool-headed and cold-hearted. They moved on. Headlines touting otherwise are fighting the last war.