The Ins and Outs of Inflation
Insights from Chief Market Strategist Marc Chandler
Inflation seems to be the buzzword of the year. Businesses cite it as one of their biggest economic concerns, and headlines vacillate between describing it as the harbinger of doom or the boy’s wolf who never came. Review the basics and hear fresh insight from Marc Chandler, Chief Market Strategist at Bannockburn Capital Markets, a division of First Financial Bank.
The Basics
Q: What is inflation and how is it measured?
A: Inflation is a rise in the general price level. There are two monthly measures: The Consumer Price Index (CPI) and the deflator of Personal Consumption Expenditures (PCE). Both measures are elevated. In June, the US CPI had risen 3.5% year-over-year, while the PCE deflator, reported with a lag, was 4.1% higher year-over-year in May.
Q: What is the difference between the CPI and PCE deflator?
A: The CPI tracks what urban households pay out-of-pocket for a fixed basket of goods. The PCE deflator casts a wider net, covering rural households and spending made on a consumer’s behalf, like employer-provided health insurance. Since 2000, CPI inflation has run an average of about 0.4% higher than the PCE deflator. The Federal Reserve targets 2% PCE deflator measure of inflation to operationalize price stability mandate. The inflation rate has overshot the 2% target since 2021.
Q: What is “core” inflation and what is its significance?
A: The core measure strips out food and energy prices. They matter, of course, but the prices are often driven by supply shocks and weather. Moreover, it appears that over time, the headline rate converges to the core rate rather than the other way around. One way to think about it is that the headline is noisy and the core offers a cleaner signal. The core CPI was 2.6% higher in June from a year ago, while the core PCE deflator stood at 3.4% in May.
The Now
Q: Why is inflation elevated?
A: There are various economic explanations, from money supply growth to the government’s deficit spending, and geopolitical developments. Many explanations begin by pointing to three supply shocks in recent years: the 2020 COVID pandemic, Russia’s invasion of Ukraine, and the US–Israel war on Iran.
The coronavirus pandemic of 2020 fractured global supply chains. Stimulus-fueled goods demand collided with constrained supply. Then, Russia's 2022 invasion of Ukraine delivered a second independent shock. It restricted access to potash and phosphorus fertilizers, lowered crop output globally, and raised costs across agricultural supply chains. The war in Iran disrupted the supply of a range of industrial supplies in addition to oil and gas, which are also feedstock for pesticides and fertilizer sulfur, helium, and aluminum. On top of it all, the US tariffs have boosted prices.
Q: Oil prices have nearly returned to pre-war levels, and gasoline prices are trending lower. Are we out of the woods?
A: The unresolved conflict in the Middle East fosters greater volatility and uncertainty. The broadening and intensification of the conflict starting in early July sent oil and gas prices sharply higher, though not (yet) through the earlier peak.
There is another risk looming: Food prices. Most nitrogen fertilizers and pesticides are manufactured from natural gas. Higher fertilizer and pesticide costs flow through to crop prices, then to food manufacturers, then to your menu and supply costs. In addition, there is weather pattern (El Niño) that periodically warms the Pacific Ocean sea-surface temperatures and disrupts global weather patterns, causing droughts in some areas, floods in others.
A recent regional survey by the New York Federal Reserve found that nearly half of the firms that were subject to tariffs are passing on the costs incrementally and plan more increases this year. On the other hand, the Bureau of Economic Analysis announced a few methodological changes that will be implemented in September 2026. They look mostly to balance out, except for how portfolio management service prices are calculated. The goal is to reduce the impact of rising equity prices and focus on employment data, specifically measuring the industry's total hours worked. The change would have shaved the PCE deflator by around 15 basis points in May.
The Future
Q: What is the outlook for US interest rates?
A: The Federal Reserve has a new chair, Kevin Warsh. He was previously a governor on the Federal Reserve’s board. He has been a critic of the central bank, and after a period of strong continuity from Bernanke to Yellen, and then to Powell, there will be a re-examination of first principles. He eschews forward guidance, which could inject more volatility into policy expectations, and therefore short-term rates. The derivatives market is pricing in about 42 bp of hikes between now and the end of the year. This is tantamount to one hike fully discounted and about an 80% chance of another.
Q: What can business owners do?
A: Best next steps will vary by business, depending on industry, reliance on supply chains, types of investments, risk appetite, and available capital. Options to consider:
- Consider price contracts with adjustment clauses or shorter renewal cycles.
- Watch core inflation, not just the headline; core tells you whether the broader pricing environment is shifting.
- Treat food and agricultural cost exposures as structural risks, not episodic ones.
- Amid firm price pressures, carry higher inventories, knowing that the supply shocks of recent years represent a more volatile environment.
Inflation may not return to 2021–2022 peaks, but the conditions that made 1985–2019 so unusually stable may not return soon.
