Even with inflation near 40-year highs, gas prices are lower than a year ago, and not just in real, inflation-adjusted terms. They’re lower even in nominal terms. The bad news is that this means that inflation right now is actually a little worse than the headline numbers indicate. The difference is not enough to cause panic, but it is something people should be aware of as the Federal Reserve prepares to raise interest rates again next week.
One reason is that inflation indices are noisy. Prices can move for millions of reasons, and not all have to do with monetary inflation. Gas prices are part of both the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index, so they can push and pull those numbers in ways that can hide what is happening with underlying monetary inflation.
The story of gas prices since COVID shows how confusing this can be. When the pandemic first hit, gas prices plummeted because many people were staying home and driving less. The national average price per gallon fell by nearly 30 percent, from $2.46 on February 3, 2020 to $1.77 per gallon on April 27, 2020.
Monetary inflation didn’t pick up until about a year later, because it takes time for new dollars to work their way through the economy—especially when the velocity of money slows, as it did during the pandemic. So, while the Fed started growing the money supply within weeks of COVID reaching America, it didn’t cause inflation right away.
In fact, CPI actually went negative from March through May 2020, due in part to that fall in gas prices, along with sudden declines in travel, hotels, restaurants, live events, and other industries. But that doesn’t mean there was deflation. And if there was, it was transitory, unlike the rapid inflation that came next.
Then in early 2021, there was a double whammy. First, the Fed’s rapid money growth and massive stimulus spending from Washington had enough time to kick in. And the first vaccines were coming out, enabling more people to return to normal. People started driving more, and this new demand meant rising gas prices. Both of these influenced CPI, though only one of them was due to monetary inflation.
So during this period, while inflation was bad, it was not quite as bad as the headline numbers said.
In early 2022, Putin’s invasion caused second gas price spike due to an unexpected supply shock. And as I wrote earlier, supply shocks are not inflation. At the same time, the Fed continued creating new money at the same rapid pace, while Congress and the White House were spending money just as fast.
Same as in much of 2021, rising gas prices exaggerated already-bad inflation in the first half of 2022.
Gas prices peaked on the week of June 13, 2022 at $5.01 per gallon. CPI peaked that month at a 1.2 percent increase. Gas was down to $3.39 by December 5, and CPI’s monthly increase was 0.4 percent or lower from July through November (the most recent available data).
Now the tables have turned. Monetary inflation is now worse than CPI shows, because falling gas prices cover up some of the underlying monetary inflation. Even so, there is reason to be optimistic going forward.
The Fed stopped creating new money in March 2022. The monetary base peaked at $6.41 trillion in December 2021 and is down to $5.34 trillion as of November 2022. This is still way above the pre-COVID level of $3.45 trillion in February 2020, and this monetary volatility can mess with the price system in ways that will likely have consequences for years to come.
We are now in the window where the Fed’s monetary tightening has had enough time to work through itself the economy. That’s why the inflation rate has likely already peaked, although it is still hard to tell for sure. Not only is there substantial month-to-month noise in the CPI, but Fed policy lag times are always uncertain, and falling gas prices are making inflation indexes look rosier than they really are.
We’re not done with high inflation yet, but we’re likely past the worst, no matter what happens with gas prices going forward. Gas prices typically increase every January, so keep in mind that early 2023 numbers will likely look a little worse than they really are.
Fed officials should keep gas prices’ distorting effects in mind as they consider interest rate increases at next week’s Federal Open Market Committee meeting and in their subsequent meeting in early February.