Focus on the Core

By ,   November 26, 2014

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Investors have been focused on “inflation watch” for a while.  The recent decline in oil prices will affect “headline” inflation numbers, but it is being suggested by some in the financial media that a reduced headline inflation number could alter the Fed’s projected path for tightening next year.  An even more speculative conclusion is that decline in oil could spur deflation.  We feel both assertations are unjustified.  

Food and energy prices have been notoriously volatile throughout history.  Supply shocks (ex. Middle East unrest affecting oil prices) for these items can create temporary imbalances and therefore spikes in prices.  By removing these transitory price changes, investors can get a better sense of long term inflation.  The Fed’s preferred metric to gauge inflation (Core PCE) removes food and energy accordingly; so while the headline number may decline with energy prices, Fed policy will not likely change unless the “core” rate declines as well.  

Secondly, the deflation arguments suggest a psychological change in consumer behavior.  In a deflationary economy, investors reduce spending because prices are expected to fall.  So the investor has incentive to wait and delay purchases, which would have a dramatic negative ripple effect over the entire economy.  In our current situation, we feel a decline in oil prices is more likely to be a stimulant the consumer spending as more disposable income is available immediately since those same dollars are not being spent on gas.  Hence, even though headline inflation may decline, it is the core inflation rate that should be a focus to determine whether or not we are heading toward a deflationary state.  

Indeed, the reduction in oil could be a key in helping sustain current inflation or even push it closer to the Fed target.  A boost in spending can help contribute to the positive feedback loop for inflation – i.e. more spending -> companies expand to meet demand -> hire more people -> lower unemployment/higher wages -> more spending.  The most recent gauge of core inflation is 1.6 and still below the Fed target of 2%.  

Fed's Inflation Gauge