Inflation: Is It Finally Back?

The much larger than expected 0.5% inflation figure today is certainly worrying, even if I wouldn’t go as far as Joe Weisenthal, who says that it “screams stagflation”. For one thing, we had negative inflation in June, of -0.2%, so there might be an element of mean-reversion here. But if you look at the 12-month inflation figures, they’re all pretty high, with a headline number of 3.6% — significantly higher than anybody at the Fed would normally feel comfortable with.

The problem is separating the signal from the noise. The Fed has one time-tested way of doing this, which is to strip out food and energy prices: if you do that, inflation was just 0.2% last month, and 1.8% over the past year. Meanwhile, energy costs have gone haywire:

It’s very hard to know what to make of a series like this, where you can have 37.2% annual inflation in fuel oil even when it’s fallen in price for three successive months, and where price volatility in fuel is closely connected to price volatility in the markets generally. Gasoline alone, with its 4.7% rise in July, accounts for fully half the headline 0.5% inflation rate — and although no one can know where gas prices are going to head going forwards, it seems improbable that they’re going to continue to rise at that kind of pace. In that sense, gas-price inflation, although certainly painful now, is not something self-perpetuating which the Fed can or should worry about when setting monetary policy.

It’s also worth remembering that the heavily-indebted US economy could do with a little bit of inflation right now, to help deflate real debts and chivvy along growth: an annual core inflation rate of 1.8%, although the highest we’ve seen since 2009, is much closer to optimal than the 0.6% number we saw last October.

So my feeling is that inflation figures, like stock-market prices, should be treated as less than gospel during this summer of volatility. Food and energy prices are crucially important parts of America’s household budgets: they can’t and shouldn’t be ignored. But there are very strong linkages between the two: 97% of the fertilizer applied to crops is manufactured from natural gas, a lot of energy is expended trucking food to supermarkets, and then of course there’s this:

If I were the Fed, I’d be looking very closely at the dynamics of food and energy prices, to work out the degree to which we’re just seeing normal market-based volatility, and the degree to which we’re seeing a secular upwards trend here which is going to have a nasty effect on inflation for the foreseeable future. That said, even if it’s the latter, it’s hard to see what the Fed can do about it. Marginally higher short-term interest rates aren’t going to have much effect on oil prices or refineries.