Inflation is back in the headlines following the “re-opening” of the U.S. economy after the economic devastation wrought by Covid-19. Standard inflation measures such as the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE) have registered their highest year-over-year change readings in more than a decade. This post will serve as a high-level introduction into CPI & PCE and provide a brief breakdown of recent CPI reports.
Measuring Inflation
The two most often quoted inflation metrics are Personal Consumption Expenditures Price Index (PCE) and the Consumer Price Index (CPI). Each measure includes a “core” and “non-core” reading – with “non-core” excluding food and energy prices, which tend to be more volatile than other consumer goods.
CPI measures the weighted average of a basket of consumer goods, determined by a survey of what households are buying. PCE measures imputed household expenditures, determined by a survey of what businesses are selling. While there is a “level” for both measures, they are generally discussed in year-over-year percentage change terms. The Federal Reserve communicates its policy goals in PCE terms, while social security benefits and financial products (such as treasury inflation protected securities) are indexed to CPI – so what is the difference?
The nuanced distinctions between PCE and CPI are explained in greater detail by Investopedia.com:
"The CPI is the most well-known economic indicator and usually gets a lot more attention from the media. But the Federal Reserve prefers to use the PCE Price Index when gauging inflation and the overall economic stability of the United States.
There are other indicators that are used to measure inflation, including the Producer Price Index and the GDP Price Index. So why does the Fed prefer the PCE Price Index? That's because this metric is composed of a broad range of expenditures. The PCE Price Index is also weighted by data acquired through business surveys, which tend to be more reliable than the consumer surveys used by the CPI.1 The CPI, on the other hand, provides more granular transparency in its monthly reporting. As such, economists can more clearly see categories like cereal, fruit, apparel, and vehicles.
Another difference between the PCE Price Index and CPI is that the PCE Price Index uses a formula that allows for changes in consumer behavior and changes that occur in the short term. These adjustments are not made in the CPI formula.
These factors result in a more comprehensive metric for measuring inflation. The Federal Reserve depends on the nuances that the PCE Price Index reveals because even minimal inflation can be considered an indicator of a growing and healthy economy.”
Recent CPI Reports
For context, we begin with a long-term chart showing year-over-year changes in the CPI. Since the spikes of the 1970s and 1980s, inflation has been more stable and has trended lower for several decades:
Although the 2021 CPI year-over-year increases do not come close to those from the 70s and 80s, they are the highest they have been in over a decade. So, what is behind the past few months of higher inflation readings?
Base Effects
As previously discussed, CPI and PCE are most often discussed in terms of year-over-year percentage changes. During Q2 2020, the CPI declined for the first time since 2008, demonstrated in the graph below.
This means that, for Q2 2021 CPI year-over-year percentage change readings, the current CPI was compared to depressed levels from during the pandemic (when the CPI had recently declined), leading to an exaggerated year-over-year increase. However, if you look at the annualized increases since Q2 2019, the increase in prices looks significantly more modest. This suggests, all else equal, year-over-year percentage increases in CPI are unlikely to sustain current levels once these base effects pass in Q3 and Q4 2021.
Supply Chain Driven Price Increases
Supply shortages have driven rapid increases in the prices of several CPI components. Most notably, used car prices have skyrocketed, showing monthly increases of 10%, 7.3%, and 10.5% for April, May, and June of 2021. This is a function of the oft-discussed global semiconductor shortage, which has limited supply, coupled with increased demand for cars following the re-opening of the U.S. economy.
The Manheim Used Vehicle Value Index, featured above, shows (i) the incredible spike in used car prices over the trailing twelve months, and (ii) that the price increase is finally starting to abate. If this trend continues, used cars will have a negative contribution to CPI – another reason why it will be very difficult for CPI readings to maintain current high levels.
The Bottom Line
Although base effects and supply chain driven price increases have contributed to higher CPI readings that are unlikely to persist, we should be careful extrapolating this too far into the future. There are no guarantees that the U.S. will revert to the disinflationary macroeconomic regime of the 2010s. Other components of the CPI report that are less likely to be temporary—such as owner-equivalent rents—have started to move higher. Furthermore, tight labor market anecdotes are abundant, which could put further upward pressure on prices. If higher inflation proves to be persistent, the implications on asset allocation and future relative sector performance could be significant.