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October 19, 2011
Share ThisLooking a little bit deeper, the increase in headline inflation is mostly with energy, and to a lesser extent, food prices. Energy prices rose 2.0%, on top of a 1.2% rise in August. While that is down from a 2.8% increase in July, it is still a big jump. Overall energy prices are up 19.3% year over year.
Breakdown of Energy
Actually the movement is even narrower than that, as energy commodities such as gasoline and heating oil were up 2.7% on top of a 1.6% jump in August. Year over year, energy commodity prices are up 32.8%. The relative pricing strength in energy commodities year over year suggests that it would be a good idea to be over weighted in the energy sector. However, oil prices fell sharply in late September, and so it is highly likely that October will show a decline in energy commodity prices, at least for the month.
Energy service prices like electricity and piped gas services have been much better contained, but are starting to "heat up." They rose 0.7% in September after three straight months of being up 0.4%. Year over year energy services prices are up 2.1%. In other words, the pain has been at the pump, not in the plug.
Oil prices have been very volatile. The price of gasoline seems to be tracking the price of Brent, which is the world benchmark, much more than the price of WTI, which is the historic U.S. benchmark. WTI has declined significantly in the recent market turmoil, but Brent much less so.
Still, it seems likely that we will see a drop in energy commodity prices in October. That said, the oil companies should post some of the best year over year growth rates in the third quarter. The growth rates of those with a more oil oriented production profile, such as Anadarko (APC) should do significantly better than those with a more of a natural gas orientation like Chesapeake (CHK).
Food Prices
Food prices have been a bit more problematic than overall inflation, but nothing like energy commodities. They rose 0.4% in September, down from a rise of 0.5% in August, and matching the July increase. Year over year, food prices are up 4.7%.
However, year over year food prices at the grocery store are rising faster than restaurant prices, and those are a lot less discretionary than going out to eat. Grocery store inflation was 0.6% for the third straight month. Year over year “food at home" inflation is 6.3%. That is hardly Zimbabwe, but it is higher than the rest of the economy. That sort of pace is taking a serious bite out of consumers' wallets, especially lower income consumers who tend to spend a much bigger share of their income on food.
Many of the key agricultural futures have doubled over the last year or so. So far they have had relatively little impact on consumers shopping at Kroger’s (KR), but that might be beginning to change. The actual cost of raw wheat is a very small fraction of the actual cost of a loaf of bread, so one would not want to exaggerate the likely impact of higher prices in the commodity pits on prices at the checkout counter. That is not as true elsewhere in the world, and rising food prices have already started to cause unrest in some countries.
Thus, if one strips out the volatile food and energy prices to get to core inflation, prices were up just 0.1%, down from 0.2% in both August and July, and a tick lower than expected. Year over year, core prices are up 2.0%. The rise in core prices is worth watching, and is a reason for concern, but not panic.
"Core" CPI
While everyone consumes food and energy, their prices tend to be extremely volatile, and can be influenced by external events. As such, the Fed tends to focus more on core prices when setting monetary policy. After all, it would not be a good idea to be tightening up on the money supply or raising interest rates simply because there is a drought in a key agricultural area of the world which drives up food prices, or because there is instability in the Middle East, which causes energy prices to rise.
Together food and energy make up just 22.8% of the total CPI. The graph below tracks the long term history of the CPI (year over year change) on both a headline and a core basis. Note that core CPI is coming off a near all-time low for the period on the graph (and I cut out the really high inflation 1970’s so you could get a better sense of the more recent movements). The year-over-year change in core CPI record low level of 0.6% was set in October, and records go back to 1957.
How the Fed May React
The rise in core inflation makes like a bit more difficult for the Fed. It has a dual mandate to both control inflation and to promote full employment. It is still doing a good job on the inflation front, although performance is slipping. At 9.1%, the unemployment situation is anything but satisfactory.
In the graph below, look at the level of inflation relative to recent history relative to the level of unemployment (green, right scale). The core rate is still very low relative to where it has been, and even the headline rate is well within the bounds of what we have been living with ever since the back of very high inflation was broken by Volker in the early 1980’s. To me this argues strongly that the Fed should be doing more to stimulate the economy, and that QE3 would probably be a good thing.
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