Bottom Line: While it was a positive development, the October inflation report did not significantly alter our assessment that there is a high risk of inflation remaining elevated in the budget year and beyond.
Our recently released Fiscal Outlook and companion report cautioned that there is a good chance inflation could remain elevated into the budget year and beyond, posing a threat to the state’s economy and budget.
Last Thursday, as we were wrapping up the Fiscal Outlook, the Bureau of Labor Statistics published the October Consumer Price Index report which showed that inflation in October was lower than it has been over the last year. The Consumer Price Index for All Urban Consumers (CPI-U) increased at an annual rate of 5.3 percent in October, compared to 7.7 percent over the last year. Similarly, “core” inflation (CPI-U excluding food and energy prices) increased at an annual rate of 3.3 percent in October, compared to 6.3 percent over the last year.
Many observers have interpreted the October report, particularly the lower reading for core inflation, as marking a significant downshift in inflation. Responding to the prospect of slower inflation, stock markets posted their best single day gains in over two years.
Has the October report changed our office’s assessment that there is a high risk of elevated inflation persisting? While positive, this report has not significantly altered our assessment. Because monthly data can be noisy, a single observation is not enough to draw firm conclusions about inflation’s longer-term trend. Illustrating this point, as can be seen on the chart above, core inflation saw similar dips in March and July of this year only to revert to higher levels in the months that followed.
Looking more broadly at past months with large drops in the core inflation reading, we do find some evidence that they tend to precede periods of declining inflation. Specifically, in the chart below we look at the 20 largest monthly drops in core inflation since 1983. Overall, core inflation is more likely to decrease than increase in the 12 months following these large drops. The median decrease in core inflation following the drops was 0.2 percentage points. Importantly, however, this historical experience is not enough to infer that the October report means inflation is close to normalizing. At its current year-over-year rate of 6.3 percent, core inflation needs to come down about 4 percentage points to return to historical norms, a much more sizable gap than the typical 0.2 percentage point decrease seen after prior large monthly drops.