Though Federal Reserve officials admit they are worried that current inflation rates are too high, many in the general public say that inflation is really worse than the Bureau of Labor Statistics (BLS) is telling us. And there are good reasons that the public is saying this. Current inflation rates at the consumer level are running at 4.0 percent year-on-year, far above the Fed's preference, with consumer prices excluding food and energy at a 2.4 percent pace.

By definition, if headline inflation is running higher than core inflation, that means food inflation, energy inflation, or both are at a higher pace than headline inflation. Currently, both are higher than headline inflation. Indeed, energy inflation in March came in at a 17 percent year-on-year pace while food was up 4.5 percent.

The public’s perception that inflation is higher than the official numbers is strongly related to the fact that food and energy inflation are running higher than headline inflation. Food and energy are key, daily items that the public consumes – they are basics in the typical household budget. When inflation is rising, these are the items that most consumers are not able to cut back on significantly. In contrast, most of the discretionary items in household budgets can be found in what economists call core inflation. Certainly, some of food and energy can be cut back during hard times but more notable discretion is found in core components such as entertainment. Another reason that many consumers see inflation as higher than reported is that the CPI is an index based on a basket of goods for an “average” consumer – essentially a household with about median income.  But we all know that not all consumers are average. Economic studies tell us – along with common experience – that households with less than median income spend a greater percentage on basics and a smaller percentage on luxuries – including on savings. Inflation on the basics will be felt more by modest income families than by high income families.

Oil is driving energy inflation

Crude oil prices have been on a strong upward trend for over more than a year, rising from roughly $50 per barrel at the start of 2007 to over $120 per barrel this week. How has this affected energy inflation?

The obvious impact of higher oil prices has been on the gasoline component of energy. Gasoline prices for March were up 26.0 percent on a year-ago basis and a cumulative 29.7 percent since the end of 2006. But gasoline prices have not risen as fast as oil prices and that may be due to different pricing strategies by oil companies over this time period. Unleaded regular has risen from $2.334 per gallon in December 2006 to $3.258 per gallon in March, according to the BLS while the American Automobile Association reports that the price in early May was an average $3.61 per gallon. An average commuter’s monthly gasoline bill has gone up 55 percent since the end of 2006 and this takes a bigger bite out of a moderate income worker’s budget than for a high income professional.

Gasoline is not the only energy component giving consumers headaches.  Heating oil costs have jumped sharply since 2007, rising 40.2 percent on a year-ago basis this March, according to the BLS. Heating oil has jumped from $2.368 per gallon in January 2007 to $3.699 per gallon in March 2008 – another crimp in the household budget, especially for modest income households in the Northeast and Midwest.

Food price detail

Food prices have jumped significantly over the past years and there are several reasons. Strong worldwide demand and shortages overseas have pushed up the cost of grains. Corn prices also have been driven up by the high cost of oil as refiners increase their use of ethanol – a largely corn-based fuel – in gasoline blends. Higher fuel costs also have boosted the cost of production for farmers.  Additionally, fertilizer is often petroleum based.

These higher production costs are clearly showing up in higher food inflation.  Two key subcomponents that are pulling food inflation higher are dairy and cereals & bakery products, up a year-on-year 11.0 percent and 8.1 percent, respectively, in March. The cost of some basic food items has risen sharply. For example, the price of fresh whole milk went from $3.00 per gallon at the end of 2006 to $3.78 a gallon this March, clearly impacting modest income families.

Not all foods have been under as intense inflation pressure. The year-ago increase for fresh fruits & vegetables has eased to 1.7 percent but this category is notoriously volatile and was as high as 6.2 percent just this January. Inflation for meats, poultry, fish & eggs has curiously also eased to a 3.7 percent pace from 5.6 percent his past October. But high grain prices can have a temporarily opposite effect as ranchers, who cannot afford large herds, send cattle to market early, temporarily driving down prices even though costs have risen. But in the long run, meat prices reflect costs incurred in production.

Food and energy shares of the household budget

The CPI should be understood as a basket of goods essentially purchased by a typical household with essentially median income. What are the component shares of the food and energy components?

These shares are based on the December 2007 relative importance weights published by the BLS.

One sees that food is just under a 14 percent share for the typical household assumed by the CPI and energy is a little under 10 percent (and includes household heating and cooling as well as gasoline). But what if food were a bigger share of the budget of a more moderate income family – and the same for energy? For example, it is very easy for gasoline costs to take up more than 5 percent of a moderate income household’s budget.

Headline inflation may be running at a 4.0 percent pace, but what if the component weights for food and energy were boosted by 25 percent?

If a more moderate income household had a budget that reflected these higher weights for food and energy, then that household would be experiencing overall inflation of 4.5 percent instead of the official 4.0 percent. And certainly moderate income households are going to notice higher prices for staples such as milk, bread, and gasoline – and these are the items showing high inflation.

The bottom line

Many more moderate income households believe inflation to be higher than official statistics. And based on higher inflation occurring in food and energy and with these being key parts of their budgets, they indeed are experiencing higher rates of inflation. This can partly explain why inflation expectations are rising with many consumers. Maintaining inflation expectations is a key issue for monetary policy and until food and energy inflation come down, inflation expectations are likely to rise. Additionally, food and energy inflation is cutting into the real purchasing power of moderate income households and this may delay economic recovery.