Headline Prices Now Run Hotter Than Core. The Wedge Is Energy.

The Number That Landed This Morning

The Bureau of Labor Statistics released the July Consumer Price Index this morning, and prices moved up 0.1 percent from the previous month, with the 12-month increase also coming in at 3.4 percent. Excluding food and energy, core prices climbed 0.2 percent, and gained 2.5 percent on a year-over-year basis. Both figures were sharply lower than their June counterparts by a tenth of a percentage point, and each landed near the median forecasts of economists.

Each one of these numbers is positive news, and a tightening of the inflation outlook on its own. The headline number showed signs of cooling for the second consecutive month, and there were no surprises of any sort at all, and certainly nothing negative at all that could have soured the outlook on the economy in this period where it is desperately needed

Now, the most important detail is not any one specific number, however. It's the relationship between two of them. With headline inflation at 3.4 percent, compared to just 2.5 percent for core, one of them is nearly a full percentage point higher than the other, and that is not normal at all.

What The Two Numbers Actually Mean

The reason behind headline CPI is fairly simple. It is a measure of the total amount a family is paying for everything, and it includes big items like gas, home heating oil, electricity, and natural gas, groceries, cars, and just about everything else that comes into the household budget. It's the number you are likely to see quoted most often, but core CPI is the more important one for the conduct of policy by the Federal Reserve.

Core inflation is simply the same calculation as headline, with the big expenditures of food and energy taken out. It seems counterintuitive to remove two of the largest budget items in the economy, but it has to do with the predictability of those costs. They tend to have far more variance from one month to the next based on forces outside the direct control of the domestic economy, such as changes in the weather and production disruptions in other countries. By removing them, you are left with a figure that has less noise and more predictive power about future movements of prices.

In a normal year, core inflation would be slightly ahead of headline, because services, which are a part of the core calculation, tend to have sticky prices that respond to changes in wages, which in turn are dictated by labor markets.

Why Things Are Different This Year

Normally, services inflation would be slightly ahead of goods inflation, because of this stickiness, and energy prices, which fluctuate up and down, are averaged out over time, smoothing them into a relatively flat line. Core inflation, therefore, tends to be a slight proxy for overall inflation trends. As a guide to future inflation, it rarely exceeds headline by much, if at all, over the course of a year

This year, headline is nearly a full percentage point ahead of core, and the culprit is clearly energy prices.

That is the most important detail in the release, actually, and the one that is likely to have the most impact on central bank policy in the months to come. The two measures of inflation are diverging, which means that at least at the margin, energy prices are still having an outsized impact on the rate increases that households are seeing from month to month.

Read that chart sideways, and it suggests that at some point over the next few years, core prices will exert more upward pressure on the price level than will energy, but that point is clearly not this year

The Chokepoint Behind the Energy Line

The details behind the energy price component are actually fairly straightforward. Brent crude traded in a narrow range between around 83 and 92 U.S. dollars per barrel throughout August, and held generally around the 87 dollar level for much of the year.

The reason behind its strength is the disruption to the supply chains through the Strait of Hormuz, which has decreased the amount of oil available to international markets. It has caused a price shock, of sorts, because suddenly, more money has to be paid for the same amount of energy than before.

Now, what makes a supply shock different from a demand shock is that it is not something that is controlled for by the central bank. If inflation is driven by pent up demand in the economy that is pushing prices up, then the Federal Reserve can act directly on the problem by slowing the economy with tighter monetary policy.

It is a self-contained loop, which is why higher interest rates will cut back on demand, cool things down, and reduce inflation. A supply shock is much more problematic, as it comes from outside the economy, and cannot be addressed directly. The same forces that make oil more expensive make everything else more expensive as well.

By raising rates, the central bank has less purchasing power for every individual in the economy, and that reduces their overall demand for goods. This may slow the rate of price increases, but it certainly does not stop them, unless demand is pushed down to the point where it is below supply.

It is an incredibly blunt instrument, and this is one of the reasons why so many economists are critical of the Federal Reserve's policy choices. There is no real solution to it, however, which is why the distinction between core and headline inflation matters so much.

Why the Fed Focuses on Core, and Why It Should Not

Monetary policymakers tend to rely on core inflation as a guide to future price pressures, because it smooths out some of these aberrations. A core CPI figure that is rising steadily is a sign that the underlying forces that drive inflation, such as wages, are increasing, and therefore the central bank should respond by reducing the money supply.

It is the most direct influence on the inflation trends, and therefore core is seen as a much better barometer for them, a useful guide to future trends.

The figure of 2.5 percent for core is actually quite close to being within the target inflation range, which is why central banks around the world tend to favor core as a policy guide. It is the most reliable indicator available, and it suggests that tightening monetary policy is the right thing to do, because it should slow demand and ultimately cool inflation.

The reason why it should not be the only guide, however, is simple: no household budget is actually calculated using the core CPI figure. Families spend money on energy and food, just as much as on services or other goods. Sooner or later, higher prices for those items will begin to show up as expenses in the average household budget, just as they always have.

If the spike in energy prices persists, it will cause prices for everything else to rise as well, because transportation costs will climb, and those costs are ultimately passed on to consumers. Air fares would become more expensive, and plastics and fertilizers would see higher prices as well, because those industries are reliant on natural gas.

The energy shock would ultimately work its way into everything, which means that core and headline would no longer have much of a spread between them.

There is a more direct reason why inflation expectations should be focused on headline CPI, however, and it is tied to the expectations of workers and businesses. Inflation expectations are formed by what people see on a regular basis, and what they expect in the future, and these factors combine to create a self-fulfilling prophecy about prices.

If businesses see 3.4 percent year-over-year inflation, then they will begin to build those higher costs into their prices, because it is the reality they see around them. Workers, too, will push for higher wages, knowing that their purchasing power would be eroded if they did not. Inflation of that sort is much harder to control, but it ultimately falls under the jurisdiction of the central bank, and is yet another reason why headline deserves more attention than core.

A Committee That Already Has Dissenters

The release of these figures comes at a particularly interesting time for the Federal Reserve, as it is already facing dissent from within about its monetary policy course. At the most recent meeting on July 29, the Federal Open Market Committee voted to leave the federal funds rate unchanged, with a target range of 3.5 to 3.75 percent. The vote was 9 to 3, however, which means there are already several members who believe tighter monetary policy should have been enacted instead.

These three dissenters were Beth Hammack of Cleveland, Neel Kashkari of Minneapolis, and Lorie Logan of Dallas, each of whom voted in favor of hiking rates rather than leaving them alone. Three dissenting votes in favor of tighter policy is the most since September 2016, and it is also the earliest such votes against a new chair have occurred since 1970.

New Federal Reserve chair Kevin Warsh has been particularly vocal about the concerns of the FOMC, stating in his semiannual testimony to Congress on July 14 that committee members have grown intolerant of higher inflation, and that longer-term inflation expectations were "largely determined by monetary policy", which is hardly a phrase used in support of easing. In effect, the dissenters may well have wanted more aggressive tightening at the last meeting, but the majority had other ideas. The battle between them and the chair is likely to continue, because the question of monetary policy is complicated, and there are multiple valid ways to interpret the evidence at hand.

The biggest issue at the upcoming meeting in September, however, is entirely different. For most of the time since the last election, members of the Federal Open Market Committee have been debating when to begin cutting interest rates, with most believing that now was the right time. This release suggests otherwise, however, because it shows that core is close to the Fed's target range, and so the most likely course of action is for the Federal Reserve to continue tightening monetary policy.

What This Print Does to September

The FOMC will meet once again in September, on the 15th and 16th, and the tightening bias remains the same. A lower core reading is exactly what the Federal Reserve needs to continue its current policy, and it is the most likely outcome at the moment. Futures markets reflect a roughly 33 percent chance of any action at all, which is not very high odds for a meeting of this importance, but it is indicative of a general uncertainty about the outlook.

Consider the views of the three dissenters mentioned earlier, however. Inflation has been running above the preferred 2 percent target for more than five years, and while core is at 2.5 percent, that is actually progress, because it is moving closer to that range.

At the same time, the headline figure is at 3.4 percent, which means the real rate the central bank is working with is barely positive at best.

The counterargument to this view is tied to the labor market, and the reason why it matters is because wages have an outsized impact on inflation. Payrolls grew by just 69,000 jobs in July, far below the 123,000 that were expected, and another 103,000 jobs were subtracted from the previous two months' totals in revisions.

Hourly earnings growth came in at 3.2 percent, the lowest it has been since May of 2021.

The Wage Side of the Ledger

That figure deserves additional scrutiny, because it is one of the clearest indications of whether or not the energy shock has begun to have an impact on expectations about inflation.

Higher wages are often the result of inflation, because if prices are increasing, workers will demand higher pay in order to maintain their standard of living. With a figure of 3.4 percent for headline inflation, one would expect to see wage growth accelerate to meet that number as well.

Instead, average hourly earnings appear to be growing at a slower pace than prices for most goods and services, which means the real value of a paycheck is either stagnant or even falling. That is hardly an ideal position for either households or firms that rely on wages as a source of revenue, but it will serve to cool inflation, because few workers are seeking higher pay at the moment.

From the perspective of the Federal Open Market Committee, however, that development is a relief, because it suggests that the energy shock has so far failed to push inflation higher in a permanent way. Households are absorbing higher prices for energy, and that is preventing them from increasing overall expenditure, which would push prices up for everything else as well. That is the mechanism by which core remains below headline in this period, because the costs of shelter are rising, but more slowly than energy prices are.

It is also a temporary state of affairs, however, because real wage compression can only occur for so long before workers push back.

The Component Doing the Quiet Work

There is one additional factor that serves to reduce the impact of energy prices on the CPI, and it is tied to shelter. It is the largest single component in the core index, and has long been known as a powerful contributor to changes in the figure, because it encompasses both rental prices and owner-occupied housing costs. Taken together, the two have the most weight in the calculation of any category in core CPI.

It is also a factor that moves slowly, because it is based on a survey of landlords, which tend to renew leases on an annual basis. Any changes in the amount of rent they charge at the beginning of a new lease take time to filter through to the CPI, because most tenants are still paying the amount they agreed to earlier in the year. As a result, the published figure for shelter is actually always a lagging indicator, one that reflects rents that have already happened.

At the moment, this lag is working in the direction of reducing the impact of higher energy prices, because the slow increase in shelter costs is preventing core from rising as quickly as prices for other goods and services.

It is entirely reasonable to be concerned about the future, as a bigger increase in rents is almost certain to occur at some point, but right now, the drag on core inflation from the slow growth in shelter costs is helpful to the Federal Reserve. It will allow policy makers to hold off on further rate increases for the time being, because core will remain below headline for the foreseeable future. It is a self-limiting process, however, because at some point this lag will disappear, and the slow growth in shelter costs will stop being a factor that offsets the increases in energy prices.

That leads to the most important consideration of all, actually. The reduction in core inflation seen in July was smaller than the reduction in headline, because of this lag that keeps shelter costs artificially low. Put another way, a significant portion of the disinflation in core is artificial, because those lower rents would not be reflected in the index if it were not for the fact that the CPI is based on a survey of landlords who renew leases only once a year. When this offset disappears, core will begin to converge on headline from below, instead of staying just below it

What Would Actually Change the Picture

There are three important developments that would change the discussion about inflation and affect the outlook for monetary policy in future meetings of the Federal Open Market Committee, and it is worth identifying them now, because they deserve careful consideration.

The first has to do with energy prices again, and their ultimate impact on inflation. If and when supply chains are re-established and prices of crude oil fall back toward their previous levels, then headline CPI will stop rising at the same pace as it has been, and move closer to core figures, without any intervention from the central bank.

The year-over-year comparisons will see a reduction in the upward pressure on prices, because it will no longer be necessary to account for the large jump in energy costs at the beginning of this year. It is actually the most likely scenario going forward, and it is not really a concern at all, from one perspective, because most inflationary pressures will dissipate on their own.

The next possibility is that core inflation will begin to accelerate again soon, and this would be the most worrying development of all. The figures for July point to an increase of about 0.2 percent, which would be entirely appropriate for the long-run trends, but two or more months of growth at this rate would indicate that energy costs have begun to trickle into the rest of the economy, pushing prices upward for everything that uses them in production or transportation.

The final possibility is tied to wages remaining low, but the danger is much more related to them rising rapidly. If average hourly earnings growth accelerates, then inflation expectations will be pushed higher as well, and that will give the dissenters plenty of reason to push for tighter monetary policy at the September meeting.

None of these three developments appear to be imminent, however, and they certainly are not apparent in this morning's release.

The Bottom Line

Inflation slowed in July, and it slowed across the board, which is great news for everyone. The detail that mattered most, however, was the detail that suggested that this slowdown was much more apparent in one measure than it was in the other. With headline far above core, the forces pushing prices higher were coming primarily from energy prices, which are outside the control of the domestic economy.

That is a vital distinction, because it has implications for the policies enacted by the central bank in response to this development. Higher interest rates have a dampening effect on demand in the economy, because they reduce disposable income, and the reduction in consumer spending ultimately lowers prices. The problem for the Federal Reserve is that demand is not really the driver behind higher prices at the moment, and it is supply constraints that are responsible for most of the increases, and constraints are not affected by tighter monetary policy.

This means the most appropriate course of action, from the perspective of the FOMC, is to continue waiting, to avoid reducing economic activity when it is not needed to reduce prices. The tightening of monetary policy can and should wait until another meeting in September, unless something changes dramatically in the coming weeks.

That is not to say there are no concerns at all, however. The most worrying prospect is the possibility that demand will begin to push prices higher in the months to come, which would make headline inflation converge on core from above as well, instead of the other way around. It is why the spread between them matters so much, and more specifically, whether or not it will narrow in the future. If the source of inflationary pressure disappears, then the central bank does not need to do anything, but if demand begins to rise, then it will have to tighten monetary policy even further in September.