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Inflation is heating up, and it's the Fed's fault




Consumer price inflation topped estimates by a bit in May, but that's only part of the bigger story. As the chart above shows, over the past six months the CPI has increased at a 5.1% annualized rate, having accelerated sharply from a zero rate in the first half of last year. That is indeed a significant pick-up. Notice also that inflation has been unusually volatile over the past 10 years (standard deviation = 2.2%), especially as compared to the prior 10 years (standard deviation = 0.7%). Three times more volatile, in fact.  This is not a coincidence, since Fed policy in the 1990s was proactive and consistently tight, whereas Fed policy since 2001 has been generally reactive and mostly easy. This is like the difference between driving by looking through the windshield compared to driving by looking in the rearview mirror.


The pickup in inflation is not limited to the headline number either. As this next chart shows, the core CPI has increased 1.5% over the past year, and as the next chart shows, over the past six months the core CPI has increased at a 2.1% annualized rate; like its headline counterpart (compare to first chart), the core CPI has accelerated meaningfully from an almost-zero rate in the first half of last year. It also has experienced significantly higher volatility in the recent decade than in the prior one. So the volatility of inflation is not just coming from food and energy prices, it's most likely coming from erratic and accommodative monetary policy. Finally, as the above chart suggests, with inflation heating up we have likely seen the lows in 10-yr Treasury yields.


To further prove my point that monetary policy is the force behind inflation, note in the chart below how the dollar was generally stronger in the 1991-2001 period, while it was generally weaker from 2002 on. Tight monetary policy keeps the dollar strong and inflation stable, while accommodative monetary policy leads to a weak dollar and more volatile and higher inflation. 


UPDATE: The chart below shows inflation according to the Cleveland Fed's Median CPI.

To calculate the median CPI, the Federal Reserve Bank of Cleveland looks at the prices of the goods and services published by the BLS. But instead of calculating a weighted average of all of the prices, as the BLS does, the Cleveland Fed looks at the median price change—or the price change that’s right in the middle of the long list of all of the price changes. According to research from the Cleveland Fed, the median CPI provides a better signal of the inflation trend than either the all-items CPI or the CPI excluding food and energy.

I have long questioned whether the median CPI is the best way to judge the underlying inflation trends. I've argued that inflation was rising long before the median CPI turned up, and I based my forward-looking view of inflation on the behavior of the dollar, gold, commodity prices, and the slope of the yield curve. In any event, it's nice to see that the median CPI now agrees with the other forward-looking indicators that I follow: inflation is heating up. It's not dangerously high by any means, but there is a clear upward trend which is likely to continue.

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