Inflation has been a prominent topic this week, with significant reports released by the Bureau of Labor Statistics on consumer prices and producer prices. Additionally, there have been reports on consumer and business inflation expectations that have piqued my interest. Overall, the news has ranged from decent to great, and although we still cannot be certain about controlling inflation without a recession, the odds are looking more favorable.
However, the message conveyed by news reports may not have been clear to everyone. This is not because the media has misrepresented the facts, but rather because much of the coverage, especially the coverage I have seen, has been disproportionately influenced by one number: “core inflation.” Core inflation refers to annual inflation rates excluding food and energy, which was a useful measure in the past but has become misleading in the post-Covid era.
Many reports I have come across have stated something along the lines of, “Headline inflation decreased in May, but core inflation remains high,” creating the impression that little progress is being made. However, a closer look at the consumer price data reveals a more nuanced situation. Over the past year, overall inflation has decreased significantly, but this is largely due to falling gasoline prices. Core inflation, which excludes these volatile gas price changes, has not decreased significantly.
Nevertheless, those who are well-informed about these numbers are aware that this comparison does not provide much insight into what is actually happening. To understand why, it is helpful to delve into the history behind the use of two different measures of inflation.
In 1975, economist Robert Gordon argued for the importance of distinguishing between inflation driven by goods with highly volatile prices, such as food and energy, and “hard-core” inflation driven by goods and services with more slowly changing prices. Inflation caused by temporary fluctuations in oil prices, for example, tends to be transient, while inflation driven by rising wages tends to persist. Excluding more volatile prices from the measure of inflation helps to extract the true signal from the noise.
As a result, the Federal Reserve began focusing on a measure of “core” inflation that excluded food and energy, historically the main sources of short-term inflation fluctuations. This focus proved valuable in the aftermath of the financial crisis, as core inflation remained subdued even amidst a brief surge in overall inflation.
Estimating a measure of core inflation to guide policy is a sound approach. However, the traditional measure of core inflation no longer effectively separates the signal from the noise. If anything, it adds more noise to the analysis.
One reason for this is that large temporary shocks now originate from sources other than food and energy, such as supply chain disruptions affecting used car prices. Moreover, traditional core inflation is heavily influenced by shelter costs, which make up around 40% of the measure. Shelter inflation primarily relies on average rent paid by tenants and an estimate known as “owner’s equivalent rent,” derived from average rents. However, average rent paid by tenants lags behind the rents paid by new tenants that more accurately reflect the current state of the economy. While this is typically not problematic, there was a significant surge in rents between 2021 and early 2022, likely driven by the rise in remote work. This surge has subsided, as indicated by private estimates of market rents and official numbers.
Consequently, the standard measure of core inflation is heavily influenced by outdated data, driven largely by rising shelter costs. However, market rents are not actually rising at an 8% annual rate; they are remaining flat or decreasing.
Moreover, in an economy experiencing significant turmoil like the one we have witnessed recently, looking at changes over a year is too long of a lag. Monthly data is too volatile, leading many economists to focus on three- or six-month changes instead. Personally, I find three-month data to be too noisy, making six-month changes a more preferable approach. Regardless, our focus should shift away from annual rates of change.
So, what should we be emphasizing instead? My current preferred measure is “super core,” which excludes used car prices and shelter. On a six-month basis, this measure clearly reflects disinflation, which may not be the message you receive from most recent reporting. Admittedly, other measures present a less clear picture, and my main intention today is not to argue that we are winning the war on inflation (although I do believe we are). Rather, I want to emphasize that news organizations should stop prioritizing estimates of annual inflation excluding food and energy. Although this measure was once useful, it is now a relic from a previous era. By including this outdated statistic in the lead of a news story, readers are misled rather than properly informed.
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