Low Inflation: Consumers See a Core Disconnect

May 17, 2019

Midway through a recent renovation, my new door knobs and new washing machine went up in price. I soon noticed prices for taxis, avocados and many other everyday items jumped too. And yet, the White House and the Fed continue to tell us that inflation is largely nonexistent and life isn’t that much more expensive. They’re wrong—it is. But in somewhat of an ironic twist, the Trump administration’s latest round of tariffs could blow their inflation cover and push the Fed’s preferred measure of underlying inflation meaningfully higher. The new tariffs could also pose a new threat to economic growth.

Why the Fed’s inflation fixation

Aside from the obvious price effects, the longer inflation remains below the Fed’s target, the less impetus there is to normalize interest rates. The lower rates remain, the fewer options the Fed has to respond to a downturn and meet its obligations, i.e., to manage the amount of money and credit in the economy via its dual mandate of promoting price stability and maximum employment.

A popular inflation theory goes something like this: Economic growth creates jobs; more jobs mean lower unemployment; low unemployment implies a tight labor market; wage increases attract workers; wage growth costs pass through to consumers; underlying core inflation rises.

Officials say that’s not happening, even though the economy’s been humming and unemployment is at a 50-year low. As of April, core inflation at 1.6% remained well below the Fed’s 2% target.

Fed Chair Jerome Powell continues to blame transitory items for the low inflation readings. What Powell called “many little things” recently includes portfolio management and investment advice services, clothing and footwear, and air transportation.1

The Fed tracks inflation to the core

The Fed monitors several price indexes to gauge inflation. Indexes come in all shapes and sizes, so the Fed weeds through what it considers the most insightful to derive a view.

Of course, the Consumer Price Index (CPI) is one. The CPI could be described as a look into what consumers are buying. It takes the weighted average of prices for a basket of goods and services deemed typical, such as food, medical and transportation. This headline number puts price changes into perspective, but it has limitations. For one, it fails to quantify production and consumption throughout the economy.

The Personal Consumption Expenditures Index (PCE), the Fed’s favorite, looks at inflation from the opposite side and tracks what businesses are selling.

Importantly, the Fed prefers core measures of the CPI and PCE. Core inflation strips out volatility often caused by food and energy prices. According to the Fed, large fluctuations in these prices from one reading to the next does not necessarily make a trend.

Consumers see inflation differently

For consumers, hypothetical baskets of goods and services that measure inflation seem just that—hypothetical, and divorced from everyday life. These baskets tell the Fed that its “Goldilocks” 2% inflation scenario remains elusive, i.e., annual inflation that is neither too hot nor too cold. But the Fed’s monetary policy porridge differs from what consumers are actually paying for porridge. And our porridge keeps going up, along with other staples.

Excluding more price-sensitive components may make sense from a monetary policy standpoint. But food and energy costs are essentials in any consumer’s budget.

Consumers note that, among others, expenses related to food, education, housing, renovation and transportation costs are higher. In April, gasoline prices jumped 5.7% after rising 6.5% in March. Food prices actually dipped 0.1% on the month, but only after rising 0.3% previously. An owners equivalent rent measure increased 0.3% for the second straight month, so did health care prices.

Trade war a culprit and a growing risk

A recent Centre for Economic Policy Research report notes that prices of intermediates and final goods increased significantly in 2018. The report highlights an almost complete pass-through of the tariffs to US domestic prices of imported goods. Another way to say it is that the rhetoric coming from this administration is not based in fact.

“The entire incidence of the tariffs fell on domestic consumers and importers, with no impact so far on the prices received by foreign exporters.”2 The report also notes that producers raised prices due to less competition for imports.

What amounts to a tax on the US consumer figures to become more significant with the White House increasing tariffs from 10% to 25% on $200 billion of Chinese goods on Friday, May 10. China responded with countermeasures slated for June 1. Not surprisingly, the markets did not react well.


Items excluded from core inflation measures could be poised to slow growth. We estimate rising oil prices could lower GDP, mainly through domestic demand. We continue to look for higher headline inflation than underlying core inflation in 2019 and 2020, but the latest round of tariffs could help close the gap. By one estimate, these tariffs could result in a 0.2 percentage point increase to core PCE.3 But this wouldn’t all of a sudden mean that inflation’s rising from the dead. Consumer wallets have felt the pinch for a while. To say otherwise is just wrong.

Category: Commentary

Topics: Macroeconomic

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