How do shifts in energy prices vary from our measures of inflation?

The most common measure of inflation in the US is the Consumer Price Index (CPI). Maintained by the Bureau of Labor Statistics (BLS), the CPI measures the average national month-to-month change in prices for a large variety of items selected as to be representative of a typical urban consumer’s purchases [1]. The month-to-month price shifts for this basket are tracked, and are weighted to produce a single percentage change in price for the average urban consumer’s spending. The analysis in this post uses the CPI-U metric provided by the BLS, which is distinct from the older CPI-W in that it measures the buying habits of all urban consumers, rather than just wage workers [1].

When a rate of inflation is mentioned in the news, it is common practice to refer to the “core inflation” rate, which is calculated in the same manner as the normal rate of inflation, while neglecting the price changes of food and energy, which are believed to be volatile [2]. Using the data available from the BLS’ website [3], it is clear that over the last 50 years, the price changes for all items and those for all items less food and energy have both steadily increased (shown in the first figure below), but the all-item CPI had significantly more violent shifts in price. For years in which the year-to-year inflation rate for both indices fell, the all-item rate fell more drastically, and vice-versa for those in which both indeces grew. Statistically, this works out to a yearly standard deviation of 2.94% for the all-item index and 2.67% for the index less food and energy. The second figure shows that despite this, the cumulative inflation rate of both indeces have tracked each other well over the same time period, despite this volatility. This suggests that we could expect the inflation rate for both indices to appear similar in the long run.

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It should be noted that, in recent years, analysts have noted that while energy and food prices have tracked each other fairly well in the past, they are becoming more interlinked thanks to a rapidly growing worldwide demand for biofuels. In particular, since this data concerns only US prices, the Congressional Budget Office found reason to believe that a link had been established due to US ethanol mandates in a 2009 report [4].

In addition, a relatively small shift in energy prices for consumers can be particularly painful. Unlike most other consumption categories, it can be difficult to find substitutes for energy to save money in times of particularly high prices. It is easy for a consumer to buy cheaper food (as the saying goes, hamburger instead of steak) or reduce one’s spending on entertainment, but workers will still use energy to drive to work or heat and cool their homes. In addition, as the CPI tracks the consumption pattern of urban consumers exclusively, I expect that rural workers who may use a higher proportion of their spending on energy costs (due to longer commutes, for example), would be particularly pinched by a spike in energy prices (unfortunately, I wasn’t able to find a source proving or disproving my thoughts, so this should be viewed as only suspicion).

While shifts in energy prices, either at the pump or when heating or cooling a home, may be particularly visible, they can really be seen as more dramatic price shifts of other household spending. Perhaps the sharper uptick in energy and food prices when the price of everying rises is why these price hikes feel so much more painful than all others?

[1]: http://bls.gov/cpi/cpifaq.htm
[2]: http://www.clevelandfed.org/Research/data/US-Inflation/cpi.cfm
[3]: http://bls.gov/cpi/data.htm
[4]: http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/100xx/doc10057/04-08-ethanol.pdf

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