E-piphany

We have an interesting week ahead, at least for an inflation guy.

Of course, the CPI statistics (released this Friday) are always interesting but with all of the chatter about the “mystery” of inflation, it should draw more than the usual level of attention. That’s especially true since the mystery will cease to be a mystery fairly soon as even flawed indicators of inflation’s central tendency, such as the core CPI, turn back higher. This is not particularly good news for many pundits, who have declared the mystery to be solved with some explanation that implies inflation will stay low.

• “Amazon effect”
• Globalization
• “competition”
• Etc

The first of these I have addressed previously back in June (“The Internet Has Not Killed, and Will Not Kill, Inflation”). The second is a real effect, but it is a real effect whose effect peaked in the early 1990s and has been waning since then. I wrote something in our quarterly in Q4 last year, which is partly summarized here.

The “competition” objection is a weird one. It seems to posit that competition was pretty lame until recently, which is pretty strange. One argument along these lines is in this article by Steve Wunsch, who considers the increase in airline fees “stark evidence of a deflationary spiral in those ticket prices caused by antitrust-induced competition.” This is odd, since airlines were deregulated in 1978 and have in recent years become less competitive if anything with the mergers of Delta/Northwest in 2009, United/Continental in 2010, Southwest/AirTran in 2011, and US Airways/American Airlines in 2013. A flaccid antitrust response from the Justice Department has allowed quasi-monopolies to develop in some travel hubs, which has tended to push fares higher rather than lower. The chart below shows the relationship between Jet Fuel prices and the CPI for airfares (both seasonally adjusted) for the 20 years ended in 2014, along with the most-recent point from last month.

The highly-explanatory R-squared of 0.81 suggests that there is not much wiggle room in airline pricing. Airfares are, as you would expect under a competitive industry, roughly cost-plus with the main source of variance being jet fuel prices. This is true even though we would expect that spread to vary over time. As Mr. Wunsch would argue, the highly competitive nature of the industry is holding down the non-commodity price pressures in airfares.

The only problem is that if you extend this graph to include the last three years, the R-squared drops about 10 points:

In case it isn’t clear from that chart, the last three years have seen airfares increasingly above what we would expect from the level of jet fuel prices. The next chart makes that clear I hope by plotting the residual (and 12-month moving average to smooth out seasonal issues such as one that evidently happened last month) between the actual CPI-airfare and the level that would be predicted from the 1994-2014 relationship. As you can see, prices have been higher, and increasingly so, than we would have thought, until this last month or two – and I wouldn’t grab a lot of comfort from that yet.

Not only is this not “stark evidence of a deflationary spiral in those ticket prices caused by antitrust-induced competition,” it seems to be stark evidence of inflation in ticket prices caused by a reduction in competition thanks to airline mergers.

In reading these many articles, it always is somewhat striking to me: everybody thinks their answer is “the” answer to the mystery. But most of these authors really don’t sufficiently understand how inflation works, and what the data is showing. This is apparent to those who do understand these nuances, as an author might discuss (as the one mentioned above did) an “aberration” in cell phone inflation as if the experts are stupid for expecting inflation when cell phone services only go down. The author clearly misunderstands what the “aberration” referred to even is; in this case the aberration was an enormous one-month collapse in prices that had never been seen and has not been repeated since. (For those who are curious about the aberration, and why it occurred, and why it is likely a methodology issue rather than sign of spiraling deflation in wireless services you can see my discussion of it here.)

The mystery is simple – the Fed’s models don’t work, and don’t take into account the fact that lower interest rates cause lower money velocity. They rely on a Phillips Curve effect that they think is broken because they don’t understand that the Phillips Curve relates wages and unemployment, not consumer prices and unemployment. They focus on a flawed measure like PCE rather than on something like Median CPI which, coincidentally, is a lot higher and suggests more price pressures. The mystery isn’t why inflation isn’t rising yet – the mystery is why they think there’s a mystery.