Inflation’s Signal and Noise

Economic reports have had a strong, but frustrating start to the year. Consistent spending has sapped the momentum of inflation’s decline, while elevated job creation shows no need for policy support. Traders and forecasters (like us) have had to reconsider our expectations for rate cuts.

Frustrated by this, some have started digging through the details of the inflation reports and suggesting that we dismiss segments whose prices are rising unnaturally. We would caution against this practice.

When outcomes do not live up to our expectations, it is natural to seek root causes. The cost of shelter has been a key culprit in the United States. In the March consumer price index (CPI) report, shelter grew 5.6% year over year, while the overall index accelerated by only 3.5%. Excluding shelter, headline CPI has hovered between 0.8% and 2.3% for the past year.

Does this mean we should exclude or limit the influence of some shelter components on inflation? Defense for this notion comes from the fact that most U.S. households own their homes. Indices of rents or owners’ equivalent rent (OER) do not reflect actual mortgage payments, which are steady for most homeowners. From this perspective, it can be argued that official inflation measures are overstated.

Other approaches to measuring inflation, like the Harmonized Index of Consumer Prices used in many European nations, do not include OER. But inflation is not a tailored measure. Anyone shopping for homes or major purchases like autos has felt the effect of higher interest rates. Those are real economic headwinds.

Readers may recognize the refrain of selective exclusion. As inflation took off in 2021, we could explain that the prices of used cars and trucks were skyrocketing due to automotive supply chain disruptions; excluding them, inflation was more tolerable. In 2022, commodity markets were skewed by the Ukraine war, and inflation was less problematic if categories like motor fuel were excluded. Today, we could get a calmer reading of prices if we ignore motor vehicle maintenance and insurance. There will always be categories of inflation that lead the pack. Inflation must be understood to include some hot and cold categories, not redefined to support a narrative.