Levels Versus Rates: Why Inflation Is Slowing but Seems So High to Many

If you are ever stuck at a social gathering you don’t want to attend and feel like stirring the pot for some entertainment, here is a line you can try: “Isn’t it nice how inflation is coming down?” We suspect you might not believe how riled up the group will get! “It isn’t coming down at all—I just paid over $40k for a mid-market sedan with bare-bones trim!” one acquaintance could say. “Eggs are nearly $10 per dozen!” another will retort, “And my weekly grocery bill is still sky-high.” At a human level, we totally get it. Inflation rates (the pace of increase) are down from last year, but that is cold comfort to the young mom paying more than $80 to fill the tank. But from a macroeconomic perspective, there is a critical divide in this thinking, and we think understanding it is key to understanding how markets have moved on from inflation so quickly.

Consumer price inflation rates, by pretty much all measures, are down bigtime from last year’s highs. The headline Consumer Price Index (CPI) inflation rate topped out at 9.1% y/y in June 2022.^[i] In August 2023, it was down to 3.7%.^[ii] The core rate, which excludes food and energy, eased from a peak rate of 6.6% in September 2022 to 4.3% in August.^[iii] And there are a bunch of other ways you can slice and dice this further to remove skew from outlying components like used cars and fake ones like owner’s equivalent rent, which no one actually pays. You can do all these things with the Personal Consumption Expenditure (PCE) price index, too. Its headline measure, which is the Fed’s targeted inflation gauge, slowed from 7.0% y/y in June 2022 to 3.3% in July, the latest figure available.^[iv] The core rate is down from 5.2% y/y in September 2022 to 4.2% in July.^[v] These are the main measures economists and the Fed refer to, and they are all down. (For all of our sanity, we are leaving politics out of this.)

But good luck convincing the average Jim and Jane that this is true. Because while inflation rates are down, prices aren’t. They are still rising, just much slower—at a rate closer to CPI’s long-term average. But for those comparing current price levels to those from before 2022, it may seem as though there have been no improvements on the inflation front whatsoever.

And here lies the disconnect, rates versus levels. Policymakers are aiming for disinflation, which is the technical term for slower inflation rates. But consumers, at an emotional level, seem to crave deflation—falling prices that erase last year’s spike. Intuitively, if 2022’s price spikes stemmed from a temporary money supply burst and pandemic supply disruptions, many people want prices to complete a full round trip to pre-pandemic levels. Wipe the spike, mission accomplished, gas at $3.50 a gallon in the Bay Area and used cars plentiful.

But this isn’t how it works. Deflation is one of those things that sounds really great—broadly falling prices across the economy, improving purchasing power and raising living standards for all. The opposite of dastardly inflation. But in real life, while prices of select goods will fall, true, economy-wide deflation is quite rare. And, when deep, it is often a wicked side effect of a severe recession and monstrous credit crunch that destroys money supply and consumer demand. This was the backdrop of the Great Depression’s deflation. Between 1929 and 1933, Nobel-winning economist Milton Friedman estimates money supply fell -33% and money velocity (the rate at which money changes hands) plunged -29%.^[vi] Consumer and wholesale prices tanked accordingly, and you don’t need us to tell you life was hard for the vast majority of people.

Deflation was a normal after effect of bank panics throughout the late 19^th and early 20^th centuries, as Friedman’s work showed. It lingered for several years after the panics of 1893 and 1907, as A Monetary History of the United States, 1867 – 1960 explored. Bank panics took a long hiatus after the gold standard’s end and the Fed’s institution as lender of last resort, but the recession that stemmed from the slow unwinding of WWII-era economic policies in 1949 brought over a year of deflation—once again a side effect of tough times. It returned intermittently in the mid-1950s, again accompanying recession, and then it stayed away for several decades. Its return, and the only substantial deflationary spell of our lifetimes, came in December 2008, when the year-over-year CPI inflation rate dipped just below zero in the wake of the global financial crisis, which saw nearly $2 trillion in bank capital destroyed by the misapplication of a single accounting rule. Deflation sank throughout early 2009, bottoming at -2.0% y/y that July, and didn’t turn positive until November—when a favorable base effect flattered it. Then, as in the Depression, deflation was an after effect of severe banking problems that brought a deep recession and one of history’s most painful bear markets.

Today, returning the Consumer Price Index’s level to December 2020’s—before the burst of inflation we have seen recently—would require a cumulative deflation of -15.2%.^[vii] On a year-over-year basis, the only period that meets or exceeds that rate is the intense deflation of 1921, which came amid a deep recession.^[viii] Even if you adjust that cumulative deflation to an annualized rate (to account for the fact it occurred over 32 months), you find it would take a -6.0% annualized deflation rate. The only two times the US has experienced this since CPI data start in 1914? That would be the aforementioned 1921 and 1929 – 1933. It is hugely unlikely anything close to this develops.

Now, we aren’t accusing people of craving an epic financial crisis to restore prepandemic prices. Rather, this is all about expectations and having the correct ones. Not just for your personal living costs and general emotional well-being, but for stocks. Because stocks and the economy know how to move on from inflationary bursts and thrive even as higher prices get baked in. Fisher Investments founder and Executive Chairman Ken Fisher likens this process to a snake digesting a rodent. Apologies for the imagery here, but the snake swallows the critter whole, and then the poor nibblet pulses through the snake’s body until it is fully digested. Inflation works much the same way. The bulge works its way through society, starting with prices and then filtering through to wages, which enables people to reclaim prior living standards even if prices never drop. Businesses, meanwhile, are able to preserve margins because inflation’s impact on their costs and revenues often cancels. We are seeing this now: Profit margins aren’t far removed from 2021, and stocks are nearly a year into a young bull market after sinking on inflation fears (among many other fears) in 2022.

None of this is fun, especially since wages tend to follow prices at a pretty hefty lag. It may take a couple years for people to start feeling like they have the purchasing power they did in 2019. But this slow, growing path is far preferable from enduring the deep recession it would very likely take to bring price levels down again. That would probably come with widespread unemployment and a host of other negative effects. Life may not be all bluebirds and lemonade today, but we reckon modest GDP growth and slowing price gains alongside higher wage growth is the better option.