For much of the past year, interest rate doves have been eager to make excuses for inflation, blaming obscure methodological quirks in the US’s consumer price index for a stretch of concerning reports. Now, another of those peculiarities is pulling reported inflation down, but the doves are happy to look the other way.
While there were certainly positive developments to celebrate in Thursday’s CPI report, the optimists would do well to take a step back and temper their enthusiasm. The core CPI — which excludes volatile food and energy prices — rose 0.3% in October from the previous month, less than the 0.5% median forecast in a Bloomberg survey of economists. As a result, the yield on two-year Treasury notes tumbled 22 basis points, the most since June, while the Nasdaq 100 was poised for the biggest jump since April 2020. But using three months of data to adjust for volatility, the annualized pace is still running around 5.8%, far exceeding the Federal Reserve’s idea of stable prices.
The improvements stemmed largely from the CPI’s health insurance index, which plummeted for extremely technical reasons that arguably have little to do with the actual inflation Americans are experiencing. In addition, used-car prices, which surged like meme stocks during the Covid-19 pandemic, dropped back to Earth as widely expected.
The most encouraging development in Thursday’s report was the lack of any new signs of trouble. In the past year and a half, price pressures have flitted from one product category to the next, repeatedly embarrassing doves who thought the phenomenon was isolated in select parts of the CPI basket. The combination of predictable good news with the lack of new bad news must certainly be regarded as a temporary victory.
But consider the strange factors at play in October, especially health insurance.
The basic story goes like this: Health insurance policies vary greatly in features and quality, and it would be challenging to measure its inflation over time. As a result, the Bureau of Labor Statistics settled on a methodology that effectively backs out a health insurance inflation rate from the retained earnings of insurers. The data are updated once a year, and the implied inflation rate is essentially spread out evenly over 12 months. This approach generally goes unnoticed, but it started to produce some extreme outputs as a result of the pandemic economy, exerting upward pressure on medical care inflation in the past year and now poised to drag it down.
Here’s how Omair Sharif, founder and president of Inflation Insights, described the situation last month on Bloomberg’s Odd Lots podcast with Joe Weisenthal and Tracy Alloway:
So during the pandemic premiums kept rising, however benefits paid out to people went down quite substantially because of Covid and the lack of utilization of health care. So what you saw was a huge spike in retained earnings. And what that meant for the CPI was that in October of 2021, which reflected this 2020 data, health insurance jumped by 2% in the month of October.
Importantly, the quirky methodological issue won’t factor into the calculation of the personal consumption expenditures deflator, the Fed’s preferred gauge of prices, where medical-care costs are measured in a much broader manner and carry a greater weight.
Before the world was debating obscure health insurance inflation statistics, the focus was broadly on housing inflation, which enters the index with a well-documented lag relative to market prices on websites such as Zillow and Redfin. For months, doves have been focused on the housing quirk as they argued that Fed policymakers were missing the signal in the inflation data because of the lagging housing component. They’re right that it’s an issue, but many missed the forest for the trees. Now, they want to celebrate a report in which medical-care services — the broader category including health insurance — single-handedly swung the month-on-month change in the index by 0.11 percentage point, moving from a seven-basis-point pressure point to four-basis-point drag.
In the near term, the developments could certainly bolster the case for a 50-basis-point increase in the federal funds target range next month instead of the 75-basis-point ones at the Fed’s previous four meetings. But even that isn’t a sure thing because the Fed will get another CPI report before its next meeting as well as another unemployment report, which could show that the labor market is still overheated. Ultimately, the Fed is still focused on the inflation that’s in the pipeline, and the latest report only matters insofar as it informs the future. At the margin, Thursday’s report is a welcome development, but it may not change the monetary policy story as much as markets seem to think.
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