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Core inflation remains muted

January 14, 2021

Graph depicting changes in Core Consumer Price Index

Source: Bureau of Labor Statistics

The core CPI moved higher by just 0.1 percent in December to hold at +1.6 percent on an annual basis for a third straight month. Medical care and recreation prices both fell while rents continued to rise only slowly, offsetting another big gain in the apparel component. Breadth was again weak overall, as the median CPI also increased by 0.1 percent and is now up by a three-year low 2.2 percent annually.

These numbers notwithstanding, it remains likely that core inflation will reset higher in the intermediate-term future as the economy continues to normalize. It is worth remembering that the core index didn’t complete similar post-recessionary adjustments in the last two cycles until 2005 and 2012, respectively, roughly three years into the expansion in both cases. The timeline should prove to be more attenuated in this recovery given that last year’s recession was much more a supply shock than a demand shock, but the process is starting slowly due to the ongoing pandemic and recurrent lockdowns. As the crisis finally runs its course, demand, especially for services, should surge and prices should respond accordingly.

Again, this process should be thought of as a one-off recalibration rather than the beginning of a new trend. In each of the last two expansions, core inflation fell back into a mid-cycle lull before perking up again in the latter stages. Moreover, the structural dynamics that have kept price pressures largely in check over the last three decades are still in place to varying degrees (demographics, globalization, etc.) and could potentially be augmented in the years ahead by a tech-driven resurgence in productivity growth. There are upside risks, as well (aggressive monetary stimulus and the potential for a further decline in the dollar, most notably), but the experience of recent cycles suggests that the bar is still set high for these factors to translate into appreciably higher core inflation, at least in the early part of the expansion. Note that even the inflation shocks of the 1970s and 1980s were largely late-cycle events, with the annual change in the core CPI peaking only after the 1961-69, 1970-73, and 1975-80 expansions.

Longer term, it is easy to imagine that monetary policy responses to economic and financial market downturns will continue to grow more aggressive from cycle to cycle – note the increasingly aggressive Fed actions across the last three recessions – and that inflation will re-emerge more sustainably as a result. It is reasonable to believe that it may even happen in this cycle given the unprecedented Fed actions in 2020 and the potential for accommodation to remain in place for several years to come. The historical trend and the prevailing fundamentals both suggest that such a development would play out only after this nascent expansion is well advanced, however, even if there is a bit of a rollercoaster ride in the interim.


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