Tuesday, December 29, 2020

St. Louis Fed: Food Prices As An Indicator Of Future Inflation

An interesting commentary, especially in light of the generations of Econ profs admonishing against putting much weight on headline inflation, as food and energy prices are volatile and should be stripped out to reveal core CPI and PPI trends.

From the Federal Reserve Bank of St. Louis, January 1, 2002:

Predicting Inflation: Food For Thought

"When I was your age, I walked 20 miles uphill in the snow to get to school and a gallon of milk only cost a nickel."Who doesn't remember grandparents and relatives sharing similar stories with us at family get-togethers? Today, a gallon of milk at the grocery store will cost more than a nickel, as will other goods that our grandparents paid considerably less for in their day. The overall rise in prices is known to economists as inflation.

Over the long run, inflation is caused by too much growth in the money supply. Monetary inflation is bad because it obscures the price signals that make our market system work efficiently. The job of monetary policy is to supply just the right amount of money so that the average price level remains stable.

Over short periods, however, inflation can be influenced by large changes in the market for particular goods and services. Because these bouts of inflation tend to be short-lived and self-correcting, the proper monetary policy response is to ignore them. The problem for the Federal Reserve is to know when inflation is due to excessive monetary growth (requiring a policy response) and when it is due to transitory market fluctuations. To sort out the short-run real effects caused by disruptions to particular markets from the long-run monetary effects caused by Federal Reserve policy, economists have developed techniques to filter the inflation news. Traditionally, economists have excluded food and energy prices in their filtering process, but we find that by filtering out food prices, we might be losing valuable information about inflation.

What's in the Basket?

Economists looking at inflation generally track a price index, which is the average price of a consistent "basket" of consumer goods. The two major price indexes are the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCEPI).

The CPI, reported by the Bureau of Labor Statistics, was created for the specific purpose of adjusting veterans' pension benefits for inflation following WWI, while the PCEPI, reported by the Bureau of Economic Analysis, is used to compute the nation's Gross Domestic Product. Both indexes measure the rate of inflation faced by consumers, but the PCEPI is more comprehensive.

Approximately 25 percent of the items in the PCEPI basket are excluded from the CPI basket. A guiding principle for deciding whether an item belongs in the CPI basket is whether it is paid for "out of pocket." The main items in the PCEPI that are not included in the CPI are things that consumers get but don't pay for out of pocket, such as free checking, employer-funded medical care and medical services paid through Medicare and Medicaid. Also, the CPI is an index of inflation for urban dwellers; so, it excludes spending by rural households.

The PCEPI, then, is a larger and broader index that includes a more varied bundle of goods than the CPI does. Although both are valid for gauging inflation, in 2000 the Federal Reserve began reporting its inflation forecasts in terms of the PCEPI instead of the CPI. Because of the PCEPI's wider basket of goods and the Fed's focus on it, we'll look only at the PCEPI, although our conclusions also apply to the CPI.1

When tracking inflation, people monitor data releases to predict the underlying inflation trend, which is driven solely by monetary policy. However, information about the inflation trend has been compared to a radio signal that is obscured by static. Just as noise filters are used to remove the static in radio signals, economists filter inflation data to remove the static caused by supply and demand changes. One way to filter the inflation news is to measure the change in prices over a long period, such as a year, to eliminate the short-run fluctuations. But then, the useful information is delayed for a year.

Another way that economists filter out the static is to delete the items in the price index that are sensitive to large, frequent disturbances to supply and demand and, therefore, have highly volatile prices. After deleting these items, what is left is core inflation, that is, inflation in the basket of goods excluding the more volatile components. Since the 1970s, core inflation has typically been measured by excluding food and energy from the basket of goods. This is because the early 1970s saw highly volatile food prices and, soon afterward, a rapid rise in the prices of gas, oil and other energy products.

The core measure of inflation, the PCEPI excluding food and energy, has been less sensitive to temporary shocks to the economy and has seemed to have been a better barometer of the underlying trend in inflation than the all-item PCEPI. Looking at Figure 1, we see that the rate of inflation measured by the PCEPI excluding food and energy has been less volatile than with the all-item index. During times of high inflation, such as the mid-1970s and early 1980s, the PCEPI excluding food and energy did not increase nearly as much as the all-item PCEPI.When inflation dropped considerably in the middle of 1986, the index excluding food and energy did not show the same massive drop.

Let's take a closer look at the changes in the prices of components excluded from the core: food and energy. From Figure 2, we see that inflation in energy prices indeed has been very volatile, increasing and decreasing much more than the food component or the all-item PCEPI. We also see that food prices have become increasingly stable recently, while energy prices continue to fluctuate significantly.

What has caused the recent increase in the stability of food prices? Improvements in technology and a change in consumer eating habits have both contributed.2 Major advancements in the food distribution system have led to shorter lag times between picking produce at the farm and getting it into the hands of urban consumers. It is not unusual, as it once was, for a shopper in a supermarket in Chicago to be buying fresh produce grown in South America. As technological advances have reduced the cost of air freight and refrigeration, their use has become widespread and commonplace in the food industry, increasing the geographic size of the market for food and reducing the volatility of food prices.

Another change in the food distribution system is that many more people now buy their food from large grocery store chains. These large chains have an advantage over smaller specialty retailers in that they have the ability to stock larger quantities of many more different types of items. Large supermarkets purchase food directly from the producers in huge quantities, cutting the cost to themselves and their consumers.

Eating habits of the American consumer also have changed. With the hectic schedule many Americans have, people are less inclined to buy fresh fruit, vegetables, meat and poultry that may go bad in their refrigerators or require time and energy to prepare. People are much more likely to buy prepared meals at the grocery store or to eat at restaurants. The prices that consumers pay for these meals are largely expenditures on the labor used to prepare and serve the food. The price of these labor services is less volatile than is the price of the raw food products.

Should We Put Food Back into the "Core" Basket?

Because volatility in food prices has dropped in recent years, does it still make sense to exclude food from our measure of core inflation? Are we losing information about the underlying trend in inflation by removing such a stable component from the core? Indeed, by excluding food prices in our traditional analysis of core inflation, we lose more knowledge about the trend in inflation than we gain....


HT: ZeroHedge