Inflation is perhaps the least understood phenomenon in all of economics. Once thought to be driven strictly by monetary factors, inflation today is considered much more nuanced and complicated. In fact, there is considerable debate about its root causes and even how to measure it properly.
For the better part of a generation, economists were primarily concerned with inflation being too low, while the general public had little interest one way or the other. All this has changed in recent months, however; American voters now rank inflation as their top economic concern.
So what happened and what is the outlook for the future?
In March, the Consumer and Personal Expenditure (PCE) index registered a surprising 6.59% year-on-year (YoY) increase. The less volatile Core PCE index rose 5.18%, just below the 40-year high set the previous month. Rising inflation has raised the possibility of structurally higher prices and inflation expectations becoming “unanchored”, although their role in controlling the price level is far from settled.
To understand the current outlook for inflation, we first need to assess how different parts of the economy are contributing and how that affects future risks. To unravel this conundrum, I examined the more than 200 categories of goods and services included in the Core PCE index to determine whether inflation is widely distributed or limited to select categories that exert disproportionate influence. The methodology is loosely based on research from the Federal Reserve Bank of San Francisco.
To begin, I ranked each category of goods and services based on their current inflation rate relative to what it was before the COVID-19 pandemic. To do this, I ran the following regression for the period January 2010 to March 2022:
Pine treeme, you = ai + bidme, you +Eme, you
Pine treeme, you = the year-on-year log change in the price index for category “i” in month “t”
ai = regression intercept
dme, you = a dummy variable that takes a value of 1 at the start of the COVID-19 pandemic in February 2020 and 0 otherwise
bi = regression coefficient for the dummy variable
Eme, you = regression error term
The regression intercept, ai, represents the average inflation rate before the pandemic from January 2010 to January 2020. The coefficient βi is the differential intercept term and indicates the change in inflation during the pandemic period. If βi is positive and statistically significant, category inflation and is higher today than before the pandemic and is therefore classified as Trending higher. Conversely, if βi is negative and statistically significant, then category i inflation is lower today than before COVID-19 and is therefore below trend. Finally, if βi is not statistically significant, then there is no detectable difference between the two periods for category i, so it is At Trend.
Deep dive of inflation
The following table summarizes the number of categories in each group and the corresponding weight of each group in the calculation of Core PCE:
|group||No. of categories||Core weight
|Above the trend||99||54.73%|
|Below the trend||32||12.80%|
The Above Trend group consists of 99 separate goods and services and represents ~55% of the weight of the Core PCE index. Therefore, more than half of all spending is currently running above trend, putting substantial pressure on consumers’ wallets. In contrast, only 32 categories (just 13% of spending) are below their pre-pandemic trend, which has not been enough to offset rising prices elsewhere in the economy.
Finally, there are currently 78 categories classified as Trending, with inflation in line with what it was before the pandemic. With only 32% of spending, the At Trend categories have been unable to slow the upward movement of the general price level.
Goods or services?
Core PCE can be broadly broken down into 65 goods and 144 service categories. So do goods or services contribute more to inflation? To find out, I’ve broken down the trend groups by classification.
The plot below visualizes the percentage of all categories of goods and services within each of the three trend groups. Approximately 60% of all goods and 40% of all services currently operate at above-trend inflation. The At Trend group is dominated by Services, while its Below Trend counterpart is evenly split.
Percentage of goods and services by trend
Taken together, these figures imply that goods account for much of the recent acceleration in inflation. There are potential upside risks if the At Trend service categories flex further. A key determinant of keeping service prices anchored will be a sustained recovery in the labor force in service-related sectors such as housing, transportation, food service, and child care, among others.
To understand where inflation may be headed, I’ve reconstructed the price indices for the up-trend, trend-down and trend-down groups. Although 99 categories are above trend, the pace of acceleration may be cooling or turning. This would indicate some short-term reduction in the numbers of the holders. Conversely, the Below Trend numbers could be tilted higher and move from a negative net contribution to a positive net contribution. This would indicate that the headline figures may deteriorate further.
The chart below shows the year-over-year percentage change in PCE for each of the price indexes. The results show a wide acceleration between classifications. The Above Trend group started moving higher at the start of the pandemic and is currently registering a change of ~5.90% year-to-date. The previous trend categories, on the other hand, showed the most moderate inflation during the period before COVID-19, at ~1% year-on-year for almost 10 years. This rapid increase may indicate significant damage to the supply chains of the underlying goods.
PCE Inflation by Classification
The At Trend group experienced a sharp decline at the beginning of the pandemic and remained low for most of 2020, but has increased in 2021 and 2022. The 4.4% change in February is much higher than the changes that experienced the index before COVID-19, which were between 1% and 2.50%. In fact, the limited sample size may be all that keeps them on trend. This could mean that trending service categories may see higher inflation.
The trajectory of the group Below Trend may be the most intriguing of the three. Before the pandemic, Below Trend recorded higher inflation than At Trend or Above Trend, with a pre-pandemic range of about 2% to 4% amid considerably higher volatility. At the onset of COVID-19, inflation declined precipitously to the lower trend and spent most of 2020 and part of 2021 in negative territory. Below-trend absolute group deflation helped keep a lid on inflation in the broader economy, at least for a while. But now the lid may have come off.
Of the three classes, Below Trend has experienced the most dramatic snapback, from -2.4% in February 2021 to 2.4% a year later. However, it remains below the high end of its pre-pandemic range. This suggests short-term upside risk as below-trend categories continue to recover.
So how will these trends influence the Core PCE title? The chart below represents the cumulative contribution of each of the three compartments to Core PCE: The dark blue section represents the top trend contribution. post pandemic, the dark red section the contribution to the trend and the dark green section the contribution below the trend. The title Core PCE is overlaid in gold.
Contributions to the Core PCE by Classification
Cube rankings and their color schemes are based on post-pandemic results. A category that performs above the trend today does not mean it is pre-pandemic the contribution to Core PCE was necessarily positive. In fact, many categories running above the trend today were net decliners for most of the 2010s, as indicated by the dark blue region below zero from 2011 to 2020. Today, some categories of the trend are still reducing inflation, although there are fewer and fewer of them. of them.
As of March, Above Trend categories contribute ~3.25% to Core PCE, At Trend contributes 1.42% and Below Trend ~0.30%. As expected, very few categories are now performing to offset inflation.
Together, these data provide a developed and granular picture of where inflation is heating up and how the underlying trends are playing out. They indicate that in almost all categories, inflation is positive and accelerating. The key near-term risk seems to be that the trend categories change to the upper trend in the coming months as the sample size expands and the underlying pattern is revealed.
Ultimately, this indicates that Core PCE is likely to remain high over the coming months. This will have important implications for the conduct of monetary policy.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Jeffrey Coolidge
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