More than meets the eye in rising inflation

The headline reading for the Consumer Price Index (CPI) for May—a 5.4% increase from the year before—was the highest jump in inflation since the 2008 financial crisis. Core CPI (which excludes the volatile food and energy prices) rose 3.8% from the year before, the fastest pace of inflation since 1992.

On the surface, the recent spike in inflation could derail the economic recovery and limit Fed flexibility, though equity and bond investors appear more sanguine about the near-term effect of rising consumer prices. The Fed has consistently argued this surge in inflation is transitory and the base effects will fade by fall. Investors for the most part are buying the central bank’s argument.

A deeper look at the May CPI report provides detail on why the Fed may be correct. The Atlanta Fed breaks down the components of CPI into “flexible” and “sticky” categories. The flexible cut includes items that change price relatively frequently—e.g., new cars, gas, food, lodging, and apparel. Sticky CPI includes items where prices changes occur relatively slowly—e.g., rent, education, health care, and personal care.

In May, the flexible CPI reading was up 12.4% from a year ago, the highest reading since 1980. The sticky reading was a more modest 2.7%, above the Fed’s 2% target but in line with the average since 1990. The spike in the flexible reading is largely due to the 4.2% drop in consumer prices from a year ago, while the sticky reading in May 2020 was +2.1%. Given the path that inflation followed last year, both flexible and sticky CPI are likely to moderate in the coming months with an expected decline more pronounced in the flexible reading. Evidence indicates the flexible price measure is more responsive to changes to the economy, while sticky CPI tends to be more forward-looking and reliable indicator of future price rises.