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– November 3, 2014

Consumer Prices
After adjusting for normal seasonal fluctuations, the overall consumer price level, measured by the CPI for All Urban Consumers, rose 0.09 percent in September, after falling 0.20 percent in August (see Table 1). The CPI Core, which excludes food and energy, grew by 0.14 percent from last month, consistent with our prediction for acceleration of CPI Core in the October Inflation Report. The higher aggregate demand and lower aggregate supply that appeared last month contributed to an increase in the CPI Core this month.

Energy prices continued their three-month slide, falling 0.70 percent for the month. This more than offset the 0.30 percent increase in food prices, resulting in slower growth in the broader CPI than the growth in CPI Core.  However, on a year-over-year basis, the CPI and the CPI Core grew at similar rates, 1.66 percent and 1.74 percent, respectively.

Among the components of the CPI two stand out. One is food and beverage prices, which trended up by 2.87 percent from a year earlier—a record high since April 2012. The other is rent, rising 3.29 percent—the biggest increase since February 2009.

Whereas the CPI measures the price of a relatively fixed market basket of goods and services, the Personal Consumption Expenditure (PCE) price index more closely reflects actual consumer spending behavior. For example, consumers might choose cheaper in-season fruit or more expensive newly released electronics. In each of these cases, CPI would fluctuate more than the PCE price index.  Although the PCE price index dropped in the last month, over the past 12 months it increased by 1.46 percent, less than the CPI increase.

AIER’s Everyday Price Index (EPI) decreased by 0.22 percent in September, the third straight monthly decline in day-to-day consumer prices. The EPI decline this month is mainly due to the continuing decline in energy prices; energy prices carry more weight in the EPI than in the CPI. For a more detailed discussion of the EPI, go to

Wholesale Prices
Overall, producers experienced lower finished goods prices in September, a decrease of 0.25 percent over last month. But Finished Core, Intermediate and Crude prices all trended upward in September, even as the Producer Price Index (PPI) Crude Energy price fell by 1.49 percent (see Table 2).

It takes time for goods to move through the production process. This month’s lower prices at the final stage of production are the result of lower prices for intermediate and crude goods in the prior month. Because intermediate and crude goods prices trended up this month, finished goods prices should rise next month and beyond. The lower finished goods prices this month are only a transitory price change, and therefore they are not expected to transfer to lower consumer prices in the coming months.

Since March 2014, however, the producer price increases have outpaced consumer prices—from March through September 2014, the average 12-month growth of the PPI was 2.49 percent, compared to an average of 1.87 percent for the CPI.

Producers are reluctant to immediately pass along changes in production costs to consumers. But given the price gap between retail and wholesale levels for seven consecutive months, there is a good chance that rising producer prices will eventually drive up retail prices in the coming months.

After demonstrating strong demand last month, consumers seemed to slow their spending in September (see Table 3). Retail sales, corrected for inflation, actually fell 0.41 percent from last month, the first decline since January 2014. Falling retail sales, as an important leading indicator for near-term inflation, suggests that the inflation rate will remain low, likely ranging from 1.5 to 2.0 percent for at least the next several months.

Falling retail sales were not caused by a lack of consumer funds. In fact, real disposable personal income and consumer credit—measures of how much cash and credit consumers have to spend—both grew for the month. Real disposable personal income advanced 0.32 percent over last month, and consumer credit rose 0.42 percent, month-to-month. These measures point to increased consumer buying power, which may be felt in higher demand in the months ahead.

Besides the impact of domestic demand on prices, the global economy has played an important role in the U.S. economic landscape. Slower overseas economic growth has weakened international demand for U.S. goods and services. Table 4 presents real GDP growth rates of U.S. major trading partners in the past three years.

Compared to three years earlier, most major U.S. trading partners are suffering slower economic growth, especially the Euro area and China, indicating lower demand in those countries for U.S. goods and services, thus hurting U.S. exports (see Table 4). A decline in U.S. exports could increase the supply of domestic goods and services, putting downward pressure on domestic prices.

Moreover, relatively strong U.S. economic growth has made U.S. capital markets more favorable for international investors. As a result, the U.S. dollar has appreciated. The real trade-weighted U.S. Dollar Index to major currencies trended up by 1.33 percent in August and 2.70 percent in September. A stronger U.S. dollar resulted in lower imported goods prices. The U.S. Import Price Index fell 0.50 percent in September over last month, after falling 0.57 percent in August. Consequently, cheaper imported goods dampened domestic prices.

All in all, weak global economic growth is imposing downward pressure on the U.S. inflationary climate, both through exports and imports.

Spurred by strong demand last month, production caught up in September. Industrial production increased by 1.01 percent from the previous month, and 4.32 percent over the past 12 months (see Table 5.)

Since the U.S. economy produced more in September, the capacity utilization rate—a measure of the extent to which the nation’s production capacity is used—rose 0.76 percent, the biggest monthly increase since December 2012. This indicates that production reacted quickly to meet the strong demand of the previous month, but it was a one-time push. In September demand decreased, which may create a surplus, thereby putting downward pressure on consumer prices going forward.

Because it takes time for prices to react to changes in demand and supply, current sluggish demand and increased production both point to a near-term modest price environment in the foreseeable future. In addition, slowing global economic growth and continuously falling oil prices are contributing to moderating prices.

When money supply growth outpaces real output growth, inflation occurs. A centuries old cornerstone of responsible monetary policy posits that the ratio between money supply and nominal GDP should remain constant. In the long run, money supply growth should equal the sum of real GDP growth and inflation. But in the short run, this is not always true. Table 6 presents recent growth rates of the U.S. Money Supply M2, real GDP and inflation (as measured by the GDP price deflator).

Over the past five quarters, the above-mentioned relationship only holds for the third quarter of 2013 and the second quarter of 2014. In the other three quarters, the money supply growth far exceeded real GDP growth plus inflation. Yet, despite abundant money in circulation, we are not experiencing inflation. How can this be?

One possible explanation is that a part of the newly created money flowed to capital markets instead of chasing consumer goods and then being reflected in prices. This would explain why the yields on government bonds have remained low as the Federal Reserve tapers its asset purchases. For instance, the 10-year Treasury bond interest rate has been declining since the beginning of 2014 until August when it reached its new low of 2.4 percent.

However, the change in how the money supply affects prices and real GDP might be caused by the current economy with its anemic recovery. As the economy continues to improve, it is possible that money creation will outgrow output and then cause inflation. Despite this possibility, we don’t see a sign of runaway inflation in the near future.

To sum up, prices trended up in September from the previous month, but over the past 12 months the inflation rate is still below 2 percent. Going forward, September’s sluggish consumer demand and increased goods supply, falling oil prices, and an appreciating U.S. dollar point to a moderate inflationary climate in coming months.

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Jia Liu, PhD

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