The big news today was not the 0.2% decline in the the September CPI. It was this:
Some 65 million retired and disabled Americans are about to be hit with a double whammy -- the Social Security Administration announced Thursday there will be no annual cost-of-living benefits increase in 2016 but there may be an increase in Medicare costs.
This happened because the year over year change in the CPI in the 12 months ended September was zero. But the real news is even worse, because inflation next year is very likely to be 2%. Why? Because it's averaged about 2% per year for the past 1, 5, 10 and 13 years, if you exclude energy prices from the calculation. Oil prices have fallen by more than half since mid-2014, and that is the primary factor driving CPI inflation to zero over the past year. Barring another big decline in oil prices—which looks unlikely given the 62% decline in active oil drilling rigs in the U.S. over the past year—the CPI is likely to continue growing at its long-term trend rate next year. If for no other reason than that the Fed wants the CPI to increase by at least 2%.
As the chart above shows, food and energy prices have contributed a tremendous amount of volatility to the CPI over the past decade or so, compared to the more stable "core" CPI.
The chart above plots the CPI ex-energy on a semi-log scale from early 2003 to the present. With the exception of a few years prior to and just after the Great Recession, prices by this measure have increased about 2% every year.
Going back to the core CPI, and calculating its annualized rate of increase over rolling 10-yr periods, we find that by this measure inflation stopped falling several years ago and is now averaging just about 2% a year. It may be premature to say this—especially since it goes strongly against the grain of current inflation expectations—but it's possible that the big secular decline in inflation that began in the early 1980s has run its course.
One reason the CPI is almost surely going to rise next year is the past behavior of housing prices. As the chart above suggests, the BLS' calculation of Owners' Equivalent Rent (which makes up about 25% of the CPI) tends to follow the rise in housing prices (as tracked by the Case Shiller index) with a lag of about one and a half years. The fact that housing prices are up 4-5% over the past year thus suggests that the OER will make a substantial and positive contribution to the overall CPI for most of next year.
So for those who depend on social security and disability payments for the bulk of their incomes—in addition to those who live on the near-zero interest rates on cash—2016 is very likley going to be a tough year, since their spending power is going to decline by about 2%.
Memo to Fed: it looks like you've been doing a pretty good job of targeting 2% inflation. No need to worry about raising rates whenever you feel like it. After all, savers could use some relief.
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