Deflating Fears With Higher Inflation

With news dominated by elections, exits and energy, here is an overlooked story: the annual Consumer Price Index (CPI) rose at its fastest rate in two years in January. Friday morning, the Fed's preferred gauge (the Personal Consumption Expenditures Price Index, PCE) followed suit. Some pundits interpret this as a reassuring sign for the US economy, assuaging both deflation fears and concerns the Fed hiked at an inopportune time last December. Yet those fears were always misplaced, in our view. Though folks are just now noticing inflation is pretty benign, the primary drag on inflation measures-plunging energy costs-is an old story.

Last week, the Bureau of Labor Statistics reported CPI rose 1.4% y/y in January, doubling December's 0.7% y/y rise. PCE basically matched the feat Friday morning. Month over month, CPI was flat after falling -0.1% in December. However, pundits were more enthusiastic about "core" CPI, which excludes volatile energy and food prices. January core CPI rose 2.2% y/y, up from 2.1% y/y in December, and 0.3% m/m-a bit higher than December's 0.2% m/m. Core PCE (again, ex-food and energy) rose a slower 1.7%, but this is still up from December's 1.5% and the fastest rate since February 2013. Highlighting core CPI, experts pointed out that prices were broadly rising in areas ranging from health care to apparel, a sign "inflation is not dead." Yet tales of inflation's "death" have always been greatly exaggerated.

Look below the surface, and the primary cause for low inflation is clear: falling energy prices. Here is a chart comparing headline and core CPI during this expansion. (Exhibit 1)

Exhibit 1: Headline vs. Core CPI, Year-Over-Year, Since 2009

Source: St. Louis Federal Reserve, as of 2/23/2016.

Now, include Energy CPI. (Exhibit 2)

Exhibit 2: Headline vs. Core vs. Energy CPI, Year-Over-Year, Since 2009

Source: St. Louis Federal Reserve, as of 2/23/2016.

Energy is pretty darn volatile, subject to big jumps and falls-hence why core gauges exclude it-and its sharp plunge since 2014 reflects oil prices' huge drop. Consider: The West Texas Intermediate benchmark crude oil price has fallen nearly -73% since June 2014.^[i]

While the year-over-year number remains negative, the decline in Energy PCE and CPI has slowed in recent readings. Though we believe energy costs will likely remain low for the foreseeable future-thanks to the global commodity supply glut-its drag on headline inflation should wane. The year-over-year comparison now uses a much lower base than, say, last summer. This, friends, is why January's annual CPI inflation rate could reach a two-year high while the monthly rate was unchanged.^[ii] Granted, we may still see some skew over the next few months as oil's "dead cat bounce" last March through June monkeys further with the year-over-year base, but this is a calculation quirk. Not a sign of actual, broad-based deflation.

This isn't an unprecedented phenomenon. Oil supply shocks have weighed on CPI and PCE before. In the mid-1980s, surging production (particularly in the North Sea) caused oil prices to collapse, putting pressure on inflation measures' Energy components and dragging down headline inflation. Exhibits 3 and 4 show the impact on CPI. Exhibits 5 & 6 show the same for PCE.

Exhibit 3: CPI Inflation Gauges and WTI Oil From 1983 - 1988

Source: FactSet, US Bureau of Labor Statistics, as of 2/23/2016. December 1983 - December 1988.

Exhibit 4: CPI Inflation Gauges and WTI Oil From 2012 - Today

Source: FactSet, US Bureau of Labor Statistics, as of 2/23/2016. December 2012 - January 2016.

Exhibit 5: PCE Inflation Gauges and WTI Oil From 1983 - 1988

Source: FactSet, US Bureau of Economic Analysis, as of 2/26/2016. December 1983 - December 1988.

Exhibit 5: PCE Inflation Gauges and WTI Oil From 2012 - Now

Source: FactSet, US Bureau of Economic Analysis, as of 2/26/2016. December 2012 - January 2016.

We obviously don't know how much this comparison will continue to hold looking forward, and inflation in the 1980s did start at higher levels compared to today (neither a good nor a bad thing). Nor, in the 1980s, did we have global central banks monkeying around with negative rates and quantitative easing, depressing bank lending and, hence, inflation.^[iii] But fundamentally, the influence of an Energy oversupply on economic data like PCE and CPI in the mid-1980s has a lot of features that remind us of today.

As the year progresses, barring a renewed and even deeper sell-off in oil prices, it's likely this year-over-year impact wanes more. While we have never been ones to fret lowflation or deflation, plenty of other folks sure did, and if they start recognizing inflation is pretty darn benign, that's one less negative weighing on sentiment.