The most recent Consumer Price Index (CPI) inflation report has been a topic of significant interest and concern. After multiple reports throughout Q1 of higher-than-expected inflation, all eyes were on this week’s report. And by all accounts, the May CPI data was a giant leap in the right direction. With headline CPI up 3.3% YoY and Core CPI up 3.4%, while still above target, the core number was the lowest in over three years. But what do these numbers really mean, and how do they relate to the broader concepts of inflation, disinflation, and deflation? Let’s dive deeper into these economic phrases.
What is inflation?
It may seem simple, but inflation is the rate at which the general level of prices for goods and services rises, decreasing the purchasing power of money. It’s measured as a percentage increase over a specific period, usually annually. When inflation is high, each unit of currency buys fewer goods and services, eroding the value of money.
What causes inflation?
Generally speaking, there are two main drivers. The first is on the demand side, which occurs when the demand for goods and services exceeds the supply. Factors like increased consumer spending, government expenditure, or investment can drive up demand. The second is on the cost/supply side, which happens when the costs of production increase, leading businesses to raise prices to maintain profit margins. Key contributors include rising wages, higher raw material costs, and supply chain disruptions.
What is disinflation?
Disinflation refers to a decrease in the rate of inflation, meaning that prices are still rising but at a slower pace. It’s important to note that disinflation is not the same as deflation (where prices actually drop). Disinflation is often a sign that the economy is stabilizing after a period of higher inflation.
What causes disinflation?
Three primary drivers of disinflation are monetary policy, decreased demand, and technological advancements. Monetary policy is a key focus, as the Federal Reserve can influence disinflation by raising interest rates or reducing the money supply to cool down an overheated economy. This week, they left rates unchanged again in pursuit of further disinflation.
Outside of monetary policy, general declines in demand from consumers or businesses reduce spending on goods and services, slowing down the rate of price increases. Finally, technological advancements can lead to lower production costs and increased efficiency, contributing to slower price increases. However, this usually takes place over a much more extended period.
What is Deflation?
Deflation is the opposite of inflation: the decline in the general price level of goods and services. While falling prices might sound good for consumers, deflation can harm the economy.
Consequences of Deflation
Since the causes of deflation and disinflation are broadly the same, the critical focus is on the consequences of deflation. The single most significant concern would be a severe economic slowdown. This can occur because as prices fall, consumers may delay purchases in anticipation of even lower prices, leading to decreased economic activity and slower growth. In addition, lower prices can reduce business revenues, leading companies to cut costs by reducing their workforce and increasing unemployment rates. When combined, these can quickly lead to a downward economic spiral.
See the chart below for examples of accelerating inflation, disinflation, and deflation from the most recent CPI report versus June 2022.
The latest CPI inflation report underscores the dynamic nature of our economy, reflecting ongoing shifts between inflation, disinflation, and deflation. Moreover, with a better understanding of the concepts above, it highlights the balancing act the Fed is undertaking while trying to produce a disinflationary environment without damaging the economy. So, while the May data shows that disinflation remains the most likely path, it is just one good report after several suboptimal ones.
Economy
- Markets were mixed again this week despite better-than-expected inflation news. The S&P 500 was up 1.6%, the Nasdaq was up 3.2%, and the small-cap Russell 2000 was down -1.0%.
- Producer prices in the U.S. were down 0.2% MoM in May, compared with market expectations of a 0.1% increase after a 0.5% rise in April.
- Core producer prices in the U.S., which exclude food and energy costs, were unchanged in May. This follows a 0.5% increase in April and is below market expectations of a 0.3% increase.
- The number of people claiming unemployment benefits in the U.S. jumped to 242K on the week ending June 8th, well above market expectations of 225K, to record the highest reading since August 2023.
Stocks
- U.S. equities were in positive territory. Technology and Real Estate were the top performers, while Energy and Financials lagged. Growth stocks led value stocks, and large caps beat small caps.
- International equities closed lower for the week. Emerging markets fared better than developed markets.
Bonds
- The 10-year Treasury bond yield decreased 22 basis points to 4.21% during the week.
- Global bond markets were in positive territory this week.
- Government bonds led for the week, followed by corporate bonds and high-yield bonds.
