Headline Inflation Accelerates, Core Inflation Slows

The Consumer Price Index – Urban Consumers (CPI) rose by 0.4 percent on a seasonally adjusted basis over the month of November and 2.2 percent over the past 12 months on a not seasonally adjusted basis. According to the release, energy prices accounted for three-fourths of the increase in the monthly change in headline inflation. Core CPI, which excludes more volatile energy and food prices, grew at 0.1 percent for the month, slower than the 0.2 percent growth rate in October, and 1.7 percent over the past year. Despite a low rate of core inflation, both headline and core inflation have averaged near 2 percent since the mid-1990s, though this has occurred within the context of broadly lower interest rates.

From a housing perspective, rental prices, a component of the Shelter Price Index, rose by 0.2 percent in October and by 3.7 percent over the past year, faster than both headline and core inflation. Over the past 12 months, real rental prices, rental prices adjusted for core-CPI rose by 1.9 percent. November marks the 76th consecutive month in which rental price growth over the past year has exceeded core inflation. Despite a slowdown in the growth of real rental prices recently, the rate of growth remains at historically elevated levels.

From a macroeconomic perspective, a previous post highlighted the relationship between the output gap and the federal funds rate. A basic Taylor Rule indicates that inflation also plays a role in the rate’s determination. The figure above illustrates how both the long-term trend in inflation and shorter-term fluctuations tracked the federal funds rate between 1961 and 1980. At the same time, the lower and falling federal funds rate between 1981 and 1993 coincided with a slowdown in inflation. Although the federal funds rate typically exceeded the rate of inflation during this period. Since 1994, the federal funds rate has trended lower, with some cyclicality, while inflation has remained broadly steady near 2 percent (PCE inflation and Core PCE inflation averaged 1.8 percent and 1.7 percent over this same time period).

If the output gap describes the short-term cycles in the federal funds rate and inflation has held about steady near 2 percent since 1994, then some other dynamic has been contributing to the downtrend in the federal funds rate. The basic Taylor rule suggests that r*, the real natural rate of interest that reflects the strength of broad economic fundamentals, might be playing such a role.

One set of estimates of r* by researchers at the Federal Reserve Bank of San Francisco suggest that this may be true. Over the period in which inflation was broadly steady near 2 percent, 1994 to the present, r* trended lower. At the same time, the declining federal funds rate between 1981 and 1993 reflected both a slowdown in inflation and a decline in r*.

However, if the analysts’ estimation of r* is correct (r* is an unobservable phenomenon), then the level of the federal funds rate between 1961 and 1980 may have been low given the estimated rate of r*. Simultaneously, r* was trending downward between 1961 and 1980, while the federal funds rate tracked upward closely matching trends in inflation. Combined, it suggests that r* may not have played as prominent of a rule in the determination of the federal funds rate during these years.



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