Is Inflation Dropping Almost 1% in Two Months Good News?

One thing we need to remember is that while the CPI is a measure of the change of prices over time it is also an indicator of aggregate demand and having the CPI fall by close to a whole percentage point in two months should give us pause.

It is just one indicator so you have to look at others to see if the CPI is showing a potential problem but unfortunately they are inconclusive, which is not bad news but it is not good news either.

We will have to wait and see if that big drop is a portent of some nasty economic clouds gathering on the horizon or if it is just the echo of the massive disruption that the pandemic caused and continues to cause.

You all may recall that when we were all sent home in March of 2020 and told to stay home inflation tanked. It dropped so far that for the months of April and May we were actually in deflation territory, with the topline yearly inflation number dropping into the negative and month-over-month dropping significantly into the negative for those two months. Then the impacts of the CERB and other government supports hit and inflation flattened out to around 0 to 0.5 percent. 

In other words, aggregate demand tanked. Everybody stopped buying except for the bare essential. However, the desire to spend money did not abate, we all just had to wait, causing a huge increase in pent up demand. Then in 2021, when the worst of the pandemic was over and vaccination rates were high enough we all decided to begin spending again with a vengeance. From haircuts to houses we went on a spending spree but before manufacturers could ratchet up production again and the supply chains that had been broken by the pandemic could be reestablished. Naturally, inflation spiked, everywhere, and then the war in Ukraine just made it worse.

That spending spree could not be sustained. It was already falling off before the high inflation and the higher interest rates that came with it cause an even bigger reduction in demand.

So again, demand fell, although not to the levels of the pandemic. That is what we are seeing with the steady decline in inflation in this country over the last year. Like many things in economics the precipitous decline in the last couple of months could just be an indication of an overcorrection, something that happens often in economics. Then again, it could be a harbinger of something bigger and nastier.

We will have to wait for the inflation data for the next few months to determine which one is true. If it is a harbinger then inflation will probably go down again and we should begin to worry. If it is just an overcorrection we should see inflation increase again, probably into the 2 to 2.5% range in the coming months and stabilize there.