Inflation can be broken into two parts, those prices that are sticky and those that are flexible. Inflation as measured by the indices will have a permanent and temporary effect. If we can decompose these two components we can have a better idea where inflation may be heading. Put another way more precisely, the CPI is a combination of prices that change frequently, flexible, and those that change infrequently, sticky. An example of flexible prices will be gasoline and heating oil. which have been changing quickly for consumers.
Hence, when we get the latest CPI reading, it will be driven in the short-run by those prices that are flexible. It is important to understand the driver for inflation since it is such a critical factor in policy right now. The Atlanta Fed has a inflation project that provides useful information on this critical topic. The Fed should not want to drive policy on temporary price shocks. It should be focused on the longer-term shocks.
From the chart above, we can see that the sticky prices will follow the flexible prices, albeit slowly. When flexible prices fell almost 10% in the Great Recession, there was a slow or delayed but clear reaction with the sticky prices. It is notable that the flexible prices moved to positive territory very quickly.
Today, we are facing flexible prices which have turned negative after almost two years below the sticky index and close to zero. The sticky prices have been somewhat stable but if the flexible trend continues we should expect that overall inflation should continue to move away from the 2% Fed target. This is the chief concern of the Fed at this time, will flexible prices rise soon and will sticky prices not decline.
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