Inflation Sets Another 40-Year High: Relief Is in Sight, with Caveats

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Inflation set a new 40-year high in February. The Consumer Price Index (CPI) increased by 0.8 percent in February, which annualizes to 7.9 percent. This is up from January’s 7.5 percent, compared to the Fed’s 2 percent target. That was roughly what was expected. The Fed made no policy changes in February and the U.S. economy stayed on the same trajectory, while Vladimir Putin’s unprovoked Ukraine invasion of Ukraine sent oil prices skyrocketing. That alone counts for about a third of the increase.

That said, there are two bits of good news—kind of. The first is that in March, the Fed is finally expected to end its bond-buying program and begin raising the federal funds rate. They should have done that months ago, but better late than never. Once taken, these actions will slow money supply growth—especially ending the bond-buying program, which intentionally creates new money out of thin air. Since the Fed’s expected actions will take time to work through the economy, they will probably not show up very much in March’s numbers when those come out on April 12. There are other factors in inflation, but the Fed policy component is by far the biggest, and it is likely about to turn the corner.

The second bit of kind-of-good news is that part of the CPI’s February increase isn’t actually from inflation. Putin’s war has caused oil prices to skyrocket, and energy accounts for 7.5 percent of the CPI. The spike is enough to account for a third of the February CPI’s increase from January. Supply shocks are not inflation, since they have nothing to do with the money supply. Inflation happens when the money supply grows faster than real economic output. The current price spike, which is hopefully temporary, doesn’t have a thing to do with the amount of currency floating around. It isn’t inflation.

This non-inflation noise from supply shocks is one reason why the Fed stopped using CPI years ago. It instead uses the Personal Consumption Expenditure (PCE) index. The media continues to mostly use CPI, possibly because it typically comes in at a higher number and is more volatile, thus allowing for juicier news stories. Lawyers continue to use CPI in most contracts that contain inflation adjustments, as do government agencies when indexing salaries and penalties, which is why the Fed continues to calculate CPI.

Another way to adjust for supply shock effects is to use the Core CPI statistic, which removes volatile energy and food prices from the CPI basket of goods, but is otherwise identical. This less volatile number better captures how much prices increases are due to inflation, rather than to changes in supply and demand. These are very different things, though it can be difficult to tell which is which.

Going forward, the Fed should concentrate on getting the money supply back in sync with economic output. It should ignore the oil price shock, which is out of its control. Congress and President Biden can help reduce oil prices by repealing the Jones Act, which makes shipping domestic oil more expensive, and by removing obstacles to increasing the domestic supply. Russia accounts for about 1/30th of U.S. oil imports, which isn’t nothing, but also isn’t decisive. More liberal policies can help absorb some of the shock. But politically tempting illiberal policies, such as price controls and antitrust actions against energy producers, will only make things worse.