How are we doing on CPI price-levels (May 2012 edition)

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This post is about the Consumer Price Index (CPI). Many criticize the CPI for understating price-increases prices, but this post is not meant to critique it. I want to address two questions:
  • How has the CPI been doing?
  • What are the market-expectations for CPI, over the next few years?
Short term history: Over the last 9-years, this is what we see...

... CPI risen about 3% a year in the early part of this period.

... the housing-bust caused CPI to drift lower

... now, it seems headed back to 3% a year

Long-term history: See the chart below. Looking back 50 years, the first thing that pops out is that the range of rates (even rates averaged across 5-year periods) is very large

.CPI rose 2%-3% in the 1950's and for most of the 1960's. Then, starting in the late 1960's, it rose  inexorably to 12%

It began to drop again in the mid-1980's and early 1990s.

Since then, CPI rises have averaged around 3% per year.

So, what happens in the future? Will we see CPI rising at 6%, 8%, 10%, as in the past?

Implied market-expectation: Future implied CPI-expectation is computed by looking at the yield on two types of US government securities: regular bonds, and bonds where the government adjusts for CPI-changes ("TIPS").

Right now, the implied estimate is that CPI is that it will be about 2% for the next few years, rising to about 2.5% (annualized) over the next 5 years.

In other words, market-prices are implying low (3%) CPI levels for the next 5 years. In fact, the implied rate is low going out all the way to 2020.
Disclaimer: This post is not meant as investment advice.
Reference: Fed paper titled: "Inflation Expectations: How the Market Speaks" (2005)

Comments

  1. utabintarboMay 3, 2012 at 11:01 AM

    When comparing CPI rates, one has to normalize for how they are collected. IIRC, the formula for CPI was changed to understate the actual (if computed using a constant formula) inflation in the '90's

    ReplyDelete
  2. Realist TheoristMay 4, 2012 at 3:08 AM

    Yes, it is possible that the CPI understates day-to-day price increases by some extent, but I think it does a pretty decent job and I don't believe it is off by more than a small amount (say 1% - 2%) on an average annual basis. Of course, given the effect of compounding, even a small difference can add up over years.

    ReplyDelete

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