Behind the Inflation Numbers...

Inflation in the U.S. today remains stubbornly subdued. Since the end of the recession, annual price gains, as measured by the Consumer Price Index (CPI), have increased in the 1%-2% range. Many consumers, however, feel like the costs of the goods and services that they buy are increasing at much faster rates.

Drilling into the composition of the CPI helps explain this apparent contradiction. Housing is the largest CPI contributor, clocking in at almost 43% of the total, followed by Transportation (15%) and Food & Beverage (15%). This weighting makes little sense to Millennials living in the suburbs and taking public transportation. Medical costs and education represent only about 10% of the total, key costs for most elderly or parents saving for a college education. Since 2000, heady gains in medical costs, education and to a lesser extent housing have been partially offset by price declines in things like cellular services and apparel.

Interestingly, prices in some of the fastest growing categories appear to be moderating somewhat today. Take a look at the chart below. Over the last year, tuition at colleges and graduate schools (after scholarships and grants are factored in) grew about in line with inflation or just 1.9%. Higher education prices are following the basic laws of supply and demand. Between 1990 and 2012, the number of two and four year colleges increased by 33% to 4,726 according to the Department of Education. But thanks to demographic trends and a strong job market, college enrollment has fallen more than 4% from a peak in 2010.

This decline in pricing power represents quite a sea-change for colleges which over the last three decades increased stated tuition rates almost 400%. Scholarships and awards reached a record this year and most schools are closely examining costs and programs. This pricing dynamic is not likely to reverse anytime soon with the population of high school graduates expected to remain flat until 2023.

While the overall cost of medical care continues to rise, the rate of increase in some segments appears to be moderating. Prices for physician services, which had advanced in the 3%-5% range annually over the last several years, is increasing lately at a more modest 1% rate. Changing federal and private sector reimbursement plans are behind this reduction. While price gains in certain components of health care, may be moderating, few economists expect the upward trend of overall costs to be radically altered anytime soon.

The course of future inflation is important. For better or worse, the CPI is used to determine annual increases in Social Security and a wide range of other fixed payouts. Inflation rates will also remain a key determinant of future Federal Reserve interest rate policy. Wage gains, a key driver of all prices, will be our best gauge as to where inflation and interest rates are headed. Up until recently, wages have been surprisingly weak given the nation’s historically low employment rate. But recent evidence seems to suggest some firming here, particularly among lower paid workers (see chart above). This population is more likely to spend than the rich so any sustained pick up in wages could be good news for overall consumption trends and the economy at large.