The July CPI, out this morning, increased +0.5% over June, and 3.2% over a year ago. It was all oil prices; energy was up +3.8% for the month, +14.2% over year ago! The CPI ex food and energy was only +0.1% in July, +2.1% over July a year ago.
So which one really matters? Depends on why you are asking the question.
If you want to know how many dollars are going to be leaking out of your pocket next month pay attention to the overall (bigger) number. Unless you have made a deal with your local gas station owner to only charge you based on the “core” CPI. Good luck.
If you want to know what it means for interest rates, however, pay attention to the smaller number, which attempts to strip out commodity price increases/decreases. Why? Because the increases in oil prices that drove prices up is a big one-time increase, rather than an increase in the long-term growth rate, of prices.
The reason we are interested in secular inflation, rather than one-time bumps, when thinking about interest rates is because the expected annual rate of price gains is one component in thinking through the expected total return on goods, which are alternatives to securities in investor portfolios.
An interesting exercise is to write down in detail the factors that add up to the total after-tax return on goods on one hand, and the factors that make up the total after-tax return on bonds, on the other hand. Then examine your list for what has to be true to make total returns equal. That is the right way to understand the relation between inflation (one of the components of the return on goods) and interest rates (one of the components of the total return on bonds).
Of course, the CPI is not a very good measure of expected gains in holding real goods either. More than half of the CPI is services, and you can’t store haircuts. A better indicator would be the expected annual increases in rental prices on the stock or real estate. That number, adjusted for various transaction cost, maintenance, and tax considerations, would give you a total return on real assets to compare with the total return on securities (the interest rate) in making asset allocation decisions.
Bottom line, this CPI report is a low inflation report, and argues for lower, not higher, bond yields (4.23% on 10 year today).
What about the Fed? The Fed understands that higher oil prices are a contractionary pressure on the economy. Today’s report will not put pressure on the Fed to raise rates; it will put pressure on them to lower rates. The higher oil prices go, the more likely it is that the Fed decides rates are actually too high to keep the economy growing.