Why inflation is slowing down temporarily right now

U.S. and global inflation spiked in late-2016 and early-2017. This was primarily driven by rising oil and energy prices. Here’s why inflation in the U.S. will be flat at around 2% over the next few months.

How the inflation rate is calculated

Headline inflation is calculated as a year-over-year change in CPI. CPI is broken down into 8 components:

  1. Food and beverages (impacted by agriculture prices)
  2. Housing (energy prices are partially in this component)
  3. Apparel
  4. Transportation (energy prices are partially in this component)
  5. Medical care
  6. Recreation
  7. Education & Communication
  8. Other

The following graph illustrates the weighting for these categories.

*Keep in mind that “energy prices” like oil are prices at the pump and not prices trading on commodities exchanges.
Agriculture and energy have the strongest medium-long term impact on changes in the inflation rate. The other categories are relatively stable (after excluding random one month spikes and plunges), while agriculture and energy prices can change significantly in just a few months. Their volatility drives a lot of the change in the inflation rate.
Keep in mind that the inflation rate is a year-over-year change in prices. Thus, it doesn’t matter if oil and agriculture (e.g. wheat, corn) prices are going up or going down.  It doesn’t matter if “oil prices are so high right now!” What matters is whether oil and agriculture prices are higher or lower today vs last year.
This is why people say that oil prices lead inflation. Here’s what happens before inflation rises.

  1. Oil prices have to rise first for a few months.
  2. Then the year-over-year change in oil will increase.
  3. Then inflation will rise.

The opposite is also true for declining inflation.
U.S. inflation started to pick up by mid-2016 because the year-over-year change in oil prices finally turned positive by mid-2016!
The following shows the year-over-year change in oil prices since 2009.

So predicting the change in the inflation rate isn’t too hard. You already know what the price of oil was 1 year ago. Then you input various prices for oil in the future, which will correspond to different inflation rates in the future.
Agriculture prices aren’t as important as oil to CPI. Food and beverage prices don’t move that much in line with the market prices for agriculture products. Commodities like corn, cotton, wheat, sugar have been getting killed since 2012, but food and beverage prices have remained pretty constant! This is for 2 reasons:

  1. A lot of grocers are artificially propping up grocery prices.
  2. “Food and beverage” assumes that people will buy processed foods and eat out from time to time. Wages have gone up over the past few years, which puts upwards pressure on the “Food and beverage” component.

Why inflation is slowing down.

As you can see, oil has been flat for most of the past year at around $45-$55 a barrel.
Jeff Gundlach used various future oil prices to estimate what will happen to the inflation rate in the next few months.

Jeff tested out various scenarios for oil: $60, $55, and $50 a barrel.
Most of these scenarios point to the same result. After a surge in inflation in late-2016 and early-2017, the inflation rate will be pretty much flat over the next few months at around 2%. If oil prices fall below $50 to e.g. $45 and stay there, then inflation will probably be in the 1.7-1.9% range, which is under the Federal Reserve’s target.
However, this is not a long term concern. The supply-demand imbalance caused by fracking is slowly being resolved, and crude oil will most likely drift upwards towards $60-$70 in the next 2 years (random guess). Hence, oil will not put downwards pressure on CPI.

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