Thursday, December 15, 2022

 Year To Date Inflation  --  Not the Right Metric

During the Great Moderation, the Fed kept the inflation rate close to its target of 2%.   However, there was substantial volatility month to month.  One month, inflation would be higher than the target, but during the next month or two, inflation would be below target.   During this period, looking at inflation over the last year allowed the monthly volatility to average out and each month's result would look close to target.   In effect, inflation over the past year is an average of the monthly inflation rates for the last year.  If that average was 2%, and if the inflation rate for the current month deviates from target, the "inflation from a year ago," will show 1/12 of the deviation.   "Inflation over the last year" shows much less volatilty and suggests that the Fed is doing a better job than it is at keeping inflation on target.   Of course, the actual increase in the price level for the month is much smaller (again, 1/12) of the annual rate of increase.  

For example, last June's nearly 16% annual inflation rate was really a 1.3% increase in the price level.   If that were reveresed by much lower inflation or even deflation the next month, it isn't as alarming as it might seem.   If prices continue to rise at that rate for a year, it would be truly alarming.   

However, when inflation has risen far beyond target, as it did in the aftermath of the COVID recession, and then it has come down as it has over the last four months, looking at inflation over the past year is not at all helpful.    The inflation rate for the previous month (and really, the last few months,) is the best we have.   Of course, future inflation is what is most important, but looking at the roughly 4% CEP inflaion we have seen for the last three months (along with the deflation from last July) suggest that inflation remains substantially above the 2% target, but it is a good bit lower than the 6% from a year ago.   Looking at the inflation over the past year underestimates the progress that has been made.  

Looking at the CPI figures, November's 1.2% inflation should be considered in the context of October and September's higher numbers that were closer to 5%.   But looking at November's year to date, of 7.1% is really pretty worthless.  

Yes, the changes in the year to date inflation tell us that inflation is slowing (slowly) but inflation for the last few months are really a much better indicator.   Inflation is still too high, but nothing like 7%.  

The Fed has increase its target for interest rates at each meeting, and it has added up.   In retrospect, we know that real interest rates were very negative over the last year.   The increase in the nominal interest rate and the decrease in the inflation rate has brought them close to zero.   Comparing a nominal interest rate of 4% to a 7% year to date inflation rate greatly exaggerates the degree that the Fed continues to have a "loose" monetary policy.