Inflation Watch

The headline inflation numbers in the estimates of consumer and producer price inflation during September were pretty spectacular; in fact, yesterday’s PPI report showed a one-month increase in producer prices that was the highest in 31 years.

But most of the inflation indicated by these headline numbers was caused by one thing alone: sharply higher energy costs. The ‘core’ rate of inflation, excluding food and energy, has remained roughly constant over the past year, as the chart below indicates, despite the recent rise in energy costs.

As I’ve argued before, economists tend to focus on the core rate of inflation because it is much less volatile, and generally does a better job of revealing the underlying trends in the economy, than the overall inflation rate. Since the core rate hasn’t budged in recent months, does this mean that we don’t have to worry about the energy price spike causing a more general inflation problem in the US? Not necessarily.

The problem is that a high overall inflation rate due to energy costs could very easily spill over into a higher core inflation rate. There are two important ingredients needed for that to happen.

First, since all types of businesses are seeing their costs rise rapidly (which is what the overall PPI rate shows), they would like to pass on these higher costs to their customers. If demand is strong enough (or competition weak enough) to allow them to raise prices without losing customers, then we would expect to see them pass on higher energy costs. We haven’t seen that happen yet, but it could – if demand is strong enough.

Secondly, individuals are finding that the purchasing power of their paychecks have been sharply eroded, as the price for the average bundle of goods that they buy has risen by nearly 5% over the past year. If workers can successfully demand higher nominal wages to compensate for this loss in purchasing power, then we might start to see nominal wages rising faster, which in turn would increase business costs further and lead to even greater pressure on businesses to raise prices for all types of goods and services. However, this depends crucially on the ability of workers to extract wage increases from their employers, which in turn depends largely on the strength of the labor market.

So, do we need to worry about inflation spreading into other sectors of the economy? The answer depends on how strong you think the labor market is, and on how strong demand is more generally. If the labor market is weak, so that workers can’t demand nominal wage increases to keep up with high consumer price inflation, or if overall demand in the economy is weak, so that firms can’t raise prices, then it could well be the case that the rise in overall inflation will be a temporary blip. But if the economy is strong enough so that workers and firms can effectively pass on the higher prices that they’re facing, we may soon see the core rates of inflation moving up.