OLMIS

by Brian Rooney
Published Mar-20-2012

Price Changes in Recession and Recovery CPI Component Changes Core Inflation Core Inflation and the Federal Reserve More About the CPI

During the latest recession overall price inflation was either nonexistent or negative. All else being equal, the increased unemployment and loss of wages associated with a recession puts downward pressure on prices as demand for goods and services drops. Conversely, as the economy recovers, the increased employment and wages put upward pressure on prices as demand for goods and services rises. But prices for all products and services do not move uniformly. Some prices rise, some fall, and others stagnate. Since the Consumer Price Index (CPI) is separated into components, we can look for the products and services that are driving the overall direction of prices.

The CPI is produced by the Bureau of Labor Statistics. It is a measure of the change in prices over time of a representative market basket of goods and services for urban consumers. The CPI is estimated using a survey of consumers across the U.S. Participants list purchases and their prices, allowing the CPI to be separated into component goods and services. The broadest measure of the CPI is for all urban consumers (CPI-U) and is the one used for this analysis.

Although other factors such as money supply affect prices, recessions put downward pressure on inflation and recoveries put upward pressure on prices. The most obvious example is the Great Depression when prices dropped five out of ten years in the 1930s, falling almost 10 percent in 1932 alone.

Graph 1 shows the percentage change of inflation (as measured by the CPI-U) for the U.S. and the Portland-Salem metropolitan statistical area (MSA). The Portland-Salem combined MSA is the only area in Oregon where the Bureau of Labor Statistics calculates the CPI. It consists of Clackamas, Columbia, Marion, Multnomah, Polk, Washington, and Yamhill counties in Oregon, and Clark and Skamania counties in Washington.

The graph indicates that the Portland-Salem area tracks closely with the U.S. city average. It also shows the overall rate of inflation declined during or shortly after the recent recessions in the early 1990s and early 2000s. The most recent economic downturn is especially pronounced with the U.S. city average declining 0.4 percent and inflation in the Portland-Salem MSA negligible at a 0.1 percent increase. As the economy moved into recovery, price inflation grew. The U.S. city average increased by 1.6 percent in 2010 and 3.2 percent in 2011. Inflation in the Portland-Salem MSA rose 1.3 percent in 2010 and 2.9 percent in 2011.

The CPI measures the price changes for a market basket of goods in the U.S. and 87 geographic areas. The components of the market basket are then weighted for consumption patterns in each area. Table 1 shows the price changes for each component in the current economic downturn and subsequent recovery.

Going into the recession, the decrease in energy prices between 2008 and 2009 was the largest change to component prices. Petroleum products, including natural gas, were the driving force here. Oil prices are price inelastic, meaning that relatively small shifts in supply or demand cause large price changes.

Strong economic growth and low oil prices between 2004 and 2007 caused fewer new sources to be developed and increased demand. As a result, demand temporarily outstripped supply, leading to the price increase. On July 11, 2008, the price for West Texas Intermediate on the New York Mercantile Exchange rose to a new record of $147.27 per barrel. Most consumers will remember gasoline costing more than $4 per gallon in mid-2008. The price of oil dropped rapidly afterward as higher prices and the recession caused demand to drop. U.S. miles driven dropped 4 percent in May 2008, the largest drop in history. By the end of 2008, oil traded at around $34 per barrel. By August 2009, prices returned to $70 per barrel.

Coming out of the recession, energy is again the component with the largest change, increasing 9.5 percent in 2010 and 15.4 percent in 2011 nationally and 8.7 percent and 17.1 in the Portland-Salem MSA. Another price spike in oil and gasoline in the spring of 2011 was the driving force behind the increase.

The price of apparel, which continued to decline through the recessionary period, has been declining in most of the country for several years. Aside from downward pressure on prices caused by the recession, cheap imports and competition are also likely factors. By 2011, the price of apparel had started to climb.

In addition, the Portland-Salem area had a significant drop in prices for recreation. During the recession, demand drops most for discretionary goods and services. Many of the goods and services within recreation such as admission tickets and sporting goods are discretionary, leading to depressed demand and near flat prices at the national level and price deflation in the Portland-Salem MSA.

Price inflation for recreation has stayed low as the economy recovers due largely to the decreasing costs of in-home movies.

The increase over the past three years for the other goods and services category is due in part to increased taxes on tobacco.

Medical care is not discretionary and there are not many opportunities to take advantage of competition between suppliers. The result is that there is less downward pressure on price. Price inflation is higher for medical care than for the aggregate of all items at the national level and higher still in the Portland-Salem area. It continues to grow into the recovery, but nowhere near the annual increases of health insurance.

As was mentioned previously, energy prices, and oil prices in particular, are price inelastic and are therefore volatile. Food also has large price swings depending on transportation costs, weather and other factors that affect agriculture such as pests and disease.

By subtracting these volatile components from the CPI-U a measure of "core" inflation can be created. The concept of core inflation is to measure inflation minus volatile price movements to get a better idea of underlying long-term trends. The simplest, and probably most widely used, measure of core inflation is the CPI-U less food and energy. Graph 2 shows core inflation using the component measures of CPI-U to exclude food and energy. The underlying downward trend of annual inflation changes is more evident, particularly at the national level. For the 2008 to 2009 period, the U.S. core CPI-U increased 1.7 percent and the Portland-Salem core CPI-U increased 1.5 percent, showing that even with energy prices taken out, the rate of inflation slowed over the recession. At both the national level and in the Portland-Salem MSA, the rate of core inflation continued its downward trend into 2010 at 0.7 percent and 1.0 percent respectively. It then picked up somewhat in 2011 to 1.6 percent nationally and 1.7 percent in the Portland-Salem MSA.

Prior to 2000, the Federal Reserve closely watched core CPI as an indication of inflation. Since then the Fed has shown a preference for the core Personal Consumption Expenditures (PCE) price index. The PCE index draws extensively from CPI data, but the formula allows for the changing composition of purchases as prices fluctuate. The measure of inflation is very important in this case since one of the primary goals of the Federal Reserve is to control inflation. If inflation is rising too rapidly, the Fed will take action such as raising the federal funds rate. This causes most other interest rates to rise, cooling the economy and reining in inflation. Currently core inflation is low, so the federal funds rate remains at historic lows to help stimulate the economy.

Find the latest national and Portland-Salem figures and CPI calculators by visiting  www.QualityInfo.org and clicking on "Wages & Income." Regional economic analysis and contact information for the Bureau of Labor Statistics can be found on their website at www.bls.gov.