The Inflation Update: January 2008
Stephen G. Cecchetti
20 February 2008

Lexington , Massachusetts

I don't know much psychology, but I do know that people carry grudges.  We are all much more likely to remember slights than compliments.  And when it comes to price changes, we have very selective memories, too.  Ask nearly anyone about inflation and they are likely recall price increases.  Recently, the list will include food and gasoline.  They somehow take them as personal affronts. Probe further, and people might admit that the price of clothes has fallen, or that their phone service is cheaper; but that's not what they remember first. Looking at the Consumer Price Index (CPI) data for January 2008 through this lens of consumer psychology suggests brewing trouble.^*

This morning the Bureau of Labor Statistics reported that the all-items CPI rose 4.8 percent at an annual rate (a.r.) for the month. Lower than last November's level of 10 percent, but still high. And core measures are up, too. The traditional core CPI that excludes food and energy rose 3.8 percent (a.r.) for the month, while the Median CPI computed by the Federal Reserve Bank of Cleveland increased at a rate of 4.2 percent.  All of these monthly readings are well above their 12-month averages of between 2.5 percent (for the traditional core) and 4.3 percent (for the headline measure).

The detail in this month's report confirms some of last falls more ominous suggestion that inflation is rising across the board.  In an average month last year, over 20 percent of prices in the CPI fell and slightly more than 60 percent rose by more than 2 percent.  This month, you have to look with a microscope to find falling prices.  At the level of detail normally reported, prices fell in only five categories,  accounting for 14.5 percent of the index.  Meanwhile more than three-quarters of prices rose by more than 2 percent.  If people tell you that inflation is a problem, it is a not result of selective memory. They are just accurately reporting their experience with rising inflation.

How high is inflation?  To see, I turn to my standard rule of thumb:  Take the 6-month change in core goods and services and weight them together.  The answer this month is a not terribly frightening (0.3x0.6+0.7x3.5)=2.6 percent.  But, over the last few months, price increases have been significantly above this trend. As the policymakers would say, the risks are all on the up side.

What about those policymakers? As we all know, the Federal Reserve's Open Market Committee (the FOMC) has lowered its federal funds rate target by 225 basis points over the last six months and is poised to ease further in coming months.  Chairman Bernanke and his colleagues have argued persuasively that, when faced with large financial shocks, policy must respond quickly and aggressively.  But, as Governor Frederic S. Mishkin notes in remarks on 15 February 2008 "the flexibility to act preemptively against a financial disruption presumes that inflation expectations are firmly anchored and unlikely to rise during a period of temporary monetary easing."  For how long will this precondition be met and will the FOMC change direction if it is not?

As measured inflation goes up, one has to worry that expectations may rise, too.  And here recent data on inflation expectations are not all that reassuring. A measure of 10-year-ahead inflation expectations computed by the Federal Reserve Bank of Cleveland from indexed U.S. Treasury bonds has been rising steadily for the past year, and now stands above 3 percent.  And the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters shows a slight up tick in the same 10-year-ahead forecast to 2.5 percent.  My hope is that one of two things will happen: Either economic slack will bring inflation down, or the financial system will recover quickly.  In the first instance, low interest rates will be warranted; in the second, rates the Fed will have to as flexibly on the way up as it has been on the way down. 

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*Michael Bryan and Guhan Venkatu document that survey measures of inflation perceptions are systematically above official estimates. They find not only that inflation perceptions are biased upward, but that the extent of the bias differs by things like by sex, income level, and whether a person rents or owns their home.

Consumer Price Inflation, Various Measures
(Through January 2008, all data s.a. at an annual rate)

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Please visit my home page:
www.brandeis.edu/~cecchett