On September 17, 2010, news headlines reported that the US Consumer Price Index for August had increased by 0.3 percent. Is this a good or bad number? Unfortunately, monthly CPI changes don't tell us much. What steps can we take to make inflation data more useful for interpreting and formulating economic policy?
The first step is to convert monthly data to annual rates. If the July-to-August monthly change (which was 0.254 percent, before rounding) were to continue for a full year, the annual rate of inflation would be about 3.1 percent. Annual rates are almost universally used in discussions of economic theory and policy.
Month-to-month changes are highly volatile. To reveal the underlying inflation trend, the next step is to look at changes in the CPI from the same month a year ago rather than changes from a month ago. Since inflation was lower for most of the previous year than it was in August, the year-to-year figure that month was just 1.1 percent, much lower than the annualized monthly figure of 3.1 percent.
The next step takes into account the fact that some prices, like those for food and energy, lie largely beyond the influence of domestic monetary and fiscal policy. Those prices are set in world markets and are subject to influences ranging from world politics to weather to oil spills. To show inflation trends with volatile food and energy prices removed, the Labor Department publishes a core CPI series. The core CPI increased at just a 0.9 percent annual rate in August.
Finally, we might ask, why adjust only for food and energy prices? Why not exclude any prices that show unusual changes in a given month? The Cleveland Fed publishes just such a series, called the trimmed mean CPI. It excludes the most extreme 16% of price movements each month. Many economists see it as the clearest indicator of underlying inflation trends, an improvement over the core CPI. The trimmed-mean CPI and core CPI numbers were about the same for August, 2010, but the trimmed mean series shows a more pronounced trend toward lower inflation over the previous two years.
The bottom line: Monthly inflation figures can sometimes signal a turning point in inflation, but those turning points are just as often masked by random noise. At present, the core CPI and trimmed mean CPI show that US inflation is still on a downward trend. Expect the Fed to stick to its easy-money policy until the trend shows a clear upward turn.
Follow this link to download a free set of classroom-ready slides discussing the trimmed mean CPI and other CPI variants. You may also want to steer your students to the Cleveland Fed's nifty interactive tool for generating inflation charts using all sorts of different inflation measures.