by Marc Chandler
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(co-authored with my colleague Sam Waters)
Inflation or indeed its opposite has driven monetary policy among the largest high income economies. With nominal rates thought to be bounded by zero, the US, UK, and Japan engaged in operations to increase the size of the central bank’s balance sheets as an unorthodox channel of easing monetary conditions. European central banks demonstrated interest rates can fall below zero.
Countries have adopted different measures of consumer inflation. Few discussions seem to be informed by this fact that makes international comparisons of inflation more difficult. What we offer here is a brief comparative analysis of the headline and core inflation measures used by the US, UK, Japan, and the Eurozone.
Price stability is a mandate shared by nearly all central banks. Often central banks themselves choose precisely how this should be operationalized. The Federal Reserve and the Bank of Japan have adopted core inflation targets while the ECB and the Bank of England focus on the headline rate.
The logic of focusing on the core rate is that it is where price signals emanate. Food and energy tend to be volatile, and, therefore, obscure the signal with noise. Over the last half century in the US, headline inflation converges with core inflation, and not the other way around. In fact, a recent San Francisco Federal Reserve paper found that this year’s core inflation is a better predictor of next year’s headline inflation than the break-evens (the yield of a conventional Treasury bond minus yield of an inflation-linked security with the same maturity). Also, food and energy are often driven by supply considerations, which is something that monetary officials tend to have somewhat less influence over than demand.
Core CPI: Components / Relative Importance
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Components
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Total Index Weight
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All items less food, energy, alcohol, tobacco
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All items less fresh food
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All items less food, energy, alcohol, tobacco
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All items less food (including alcohol), energy
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* Weights subject to change
Current Inflation Status:
· Eurozone:
o Draghi and the ECB are struggling with oscillating headline CPI near the zero rate line, well below their mandate.
· Japan
o After finding a seeming floor at zero, headline CPI is near 0.3 percent. Excluding fresh food, the traditional core measurement in Japan, CPI shows slight deflation. However, Japanese officials seem to be giving more credence to measures of inflation that exclude energy too. Core CPI excluding fresh food and energy sits closer to 1.0.
· UK
o In November, headline CPI breached the positive side of the zero barrier (0.1) for the first time in the past four months.
· US
o Dragged down by energy prices, headline CPI is at zero. Core CPI reached 2.0% in November. Evidenced in the recent decision to hike interest rates, policymakers are reasonably confident that core PCE deflator, which lags behind CPI, will move 2% target in the medium term.
Headline CPI: Component Weights / Relative Importance
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*Headline CPI
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Weight (U.S.)
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Weight (Eurozone)
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Weight (Japan)
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Weight (U.K.)
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Food and beverages
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Alcohol & Tobacco
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(Actual rentals for housing)
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(Owners equivalent of rent)
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Transportation
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Medical Care
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Recreation
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Communication
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Restaurants & Hotels
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Other Goods and Services
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* Component categories and composition may not reflect official organization by central bank statistics agencies; categories have been standardized for comparative purposes. Component weights were not manipulated.
* Weights subject to change
The Effects of Housing
The housing component of CPI displays the largest discrepancy across the four weighting methodologies. Composed of shelter (rent indices), appliances, fuels and utilities, and other household goods and services, housing is responsible for about 42 percent of the entire CPI index in the United States; roughly double that of the Eurozone and the UK. Beyond nominal weight, the “shelter” factor of the housing index in each region is calculated differently.
The US includes an “owners’ equivalent rent of residences” which accounts for nearly 25% of overall CPI. The Eurozone and the UK only include actual rentals for housing as part of the shelter sub-component. When analyzing core CPI across countries, the rent equivalent becomes, even more, consequential to overall inflation. What does this mean? Ultimately, there is no explicit right or wrong when gauging consumer prices. An objective measure does not exist. CPI reveals more about the metric than prices themselves.
Some economists believe this variation in weight and definition masks the true health of the US economy relative to Europe’s, and that the United States may actually be further from target inflation than advertised.
· The US used the Eurozone’s core CPI measure:
o Core CPI in the United States is largely seen as being superficially buoyed by strong housing and medical indices, which are heavily weighted in the US but much less so in the Eurozone. If the US were to use the same methodology as the Eurozone, one might expect core inflation to be a tick lower, nearer the 0.8 to 1.1 percent range. Inflation in this range would put the US on par with the dangerously low inflation threatening the Eurozone’s economic growth and stability. Headline CPI would undoubtedly read as deflation, possibly near the -0.1 percent mark.
· The Eurozone used the US core CPI measure:
o In the past several months, the medical care index has posted consistently above the 0.1 year-over-year headline inflation rate in the Eurozone at 0.6 and 0.7 percent. Eurozone housing (excluding energy from housing) has been even stronger, displaying 1.1% year-over-year growth each month for the past quarter. Thus, we could expect a core inflation measure significantly higher than the traditional headline CPI measure used in the Eurozone, nearing the 1.0 range.
· The US used Japan’s core CPI measure:
o Traditionally, Japan core CPI is calculated as all items less fresh foods. Japan’s calculation differs drastically from other nations as they leave energy included in their core CPI rating. If the US were to include energy in its core CPI measurement, we could expect a materially lower print driven by sharply declining energy components across the board – projected at less than 0.5 percent. The heavier weight in food would not impact the number as drastically, with the food component posting a year-over-year increase close to the 1.9 percent core inflation figure.
· Japan used the US core CPI measure:
o Japan’s “shelter” subcomponent of its housing index similarly includes an imputed rent value. If Japan were to use the US core CPI measure, one could anticipate a similar data point. Weaker housing, with roughly zero inflation in recent months, along with a lower weight for food, one of the country strongest inflationary pressures, would be nullified by the exclusion of energy. Comparing Japan’s ex-food and energy to the US measurement, we would expect a more radical decrease from the 1.0 mark to zero growth or deflation.
The Eurozone, Japan, UK, and the US have different economic frictions, different headline basket weights, and different scopes for core CPI. They all find themselves in comparable inflationary environments: near zero headline inflation and slightly firmer core inflation. As inflation continues to evolve in these countries, economists can continue to evaluate if the two CPI measures are cherry-picked, inaccurate monitors of economic health or truly reflective of consumer prices.
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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