The Inflation Update: December 2006
Stephen G. Cecchetti
18 January 2006

Waltham, Massachusetts

The Greenspan era ends on in 2 weeks, and if there is one word to describe the past 17+ years it is stability, both real and nominal stability.  While real growth averaged almost exactly 3% both during his Fed tenure and during the 17 years prior to it, growth was much more stable under Greenspan.  The standard deviation of real GDP growth in the US from 1987 to 2005 was half of what it was from 1970 to 1987.  And, if this isn't impressive enough, inflation was both lower and more stable.  From 1970 to 1987 inflation, as measured by the traditional CPI excluding food and energy, averaged 6.4% at an annual rate (a.r.) with standard deviation of nearly 3 percentage points.  During the Greenspan era, prices rose at an average annual rate of 3% with a standard deviation of 1.1 percentage points. Of course, long-run averages obscure short-term trends. Recent growth has been higher (about 3.5%), and inflation lower (a bit over 2%), than the averages.

Today's inflation data is the last data release before Alan Greenpan's last FOMC meeting on January 31, his last day as Chairman.  And it clearly soft. Only the most fervent inflation hawks will find anything to worry about in this report. The headline, all-items Consumer Price Index (CPI) fell a very slight -0.6% (a.r.), core measures picked up a bit.  The CPI excluding food and energy rose 2.4%, and is up 2.2% for 12 months of 2005. This is exactly the same as the 2004 increase.  The median CPI rose 2.5% (a.r.), the same as its 12-month change.  So, the CPI inflation trend looks stable at around 2.5%.

There are a few things we will need to watch over the coming months.  First, we will have to see if pricing power really does come back.   So far, core goods prices don't show it.  Prices of commodities excluding food and energy commodities were unchanged in December, and are up only 0.2% for the year. 

At the same time, core service prices (services excluding energy services) rose 3.1% (a.r.) for the month, and are up 2.9% this past year.  Again, there doesn’t appear to be much to worry about.

The question mark is housing, which is a big part of the service component.  My recent concerns have been that rents will start to rise to catch up with the recent rises in the prices of owner-occupied homes, and that this will find its way into the CPI.  Owner-equivalent rent rose 3.1% (a.r.) for the month, well above its recent 2.5% trend.  The risk is that OER will return to the 3.5% trend of several years ago. With a 30% weight in the traditional core, for each percentage point increase in OER inflation, the inflation trend will rise 0.3%. We will need at least a few more months of data to confirm that something like this is on the way.

So, where does this leave policymakers?  Before today's numbers, expectations were that the federal funds rate target will peak at between 4.5% and 5%.  But now, it looks like the lower end is more likely.  That is, most Committee members will see no need to drive interest rates to 5%.  Energy price increases are not feeding into the rest of the economy, product and labor markets do not look under pressure, and the housing boom seems to be abating on its own.  Few Fed Governors and Reserve Bank Presidents will see any inflation risks.  Instead, I expect the January meeting to be filled with comments about the risks of a slowdown in growth.  With housing markets cooling, the wealth effects that have been supporting consumption are going to wane and growth could easily fall below 3% this year.  This is what the FOMC is going to be looking for.  While the final Greenspan meeting will almost surely result in a quarter point fed funds rate increase, since risks are perceived as tilting toward slower growth, the statement will likely be crafted to leave options open for the March meeting, Ben Bernanke's first.

Consumer Price Inflation, Various Measures
(Through December 2005, all data s.a. at an annual rate)

For previous updates, as well as my occasional essays on current policy issues,
Please visit my home page:
www.brandeis.edu/~cecchett

 (Note:  If you have trouble viewing the tables, you may prefer looking at them in html at
 people.brandeis.edu/~cecchett/pdf/inf12_05.htm)