The Inflation Update

This morning's inflation report has a few surprises in it, some pleasant but most not. The BLS release shows the all-items (headline) Consumer Price Index for February rose at somewhat surprising 4.5 percent annual rate (a.r.), well above its12-month average rate of 2.4 percent. As one would expect, the monthly change in the core inflation measures was more subdued, with the traditional CPI excluding food and energy up 2.9 percent (a.r.) while the median CPI calculated by the Federal Reserve Bank of Cleveland rose 3.6 percent. Over the past 12 months, these two core indexes increased 2.7 and 3.6 percent respectively.

As for the surprises, regular readers of this update know that I have been expecting a sustained increases in owner equivalent rent (OER) increases in excess of 4 percent per year. And with a 24 percent weight in the overall CPI, this would mean persistently high inflation readings. Well, after a few months of 4 to 5 percent increases, OER looks like it has now calmed down. This month OER rose 3.6 percent (a.r.), well below it's 12-month average of 4.2 percent. It how seems likely that we will continue along with increases in the range of 3.5 percent.

Medical care is another bright spot in today's numbers. For February, his month the combined index for medical commodities and services rose 5.9 percent (a.r.), well below the 10.1 (a.r.) increase last month. My hunch at this point is that the month-to-month volatility in these numbers is tied to seasonal adjustment problems. It may be that this year, various annual increases occurred a month earlier than they had in the past. If that's the case, then we really should be looking at the average over a somewhat longer period. Taking the 3-month average, we see that medical care rose only 4.6 percent (a.r.). Something that shouldn't worry anyone.

There are three sources of unpleasant news in the detail of the report: food away from home, core goods prices (commodities excluding food and energy commodities), and the overall distribution of price changes. Food away from home showed a 4.4 percent (a.r.) increase for the month, well above it's 12-month average of 3.4 percent. Prices of prepared food and restaurant meals do tend to be a harbinger of movements in the inflation trend, so this is clearly worrisome. Turning to core goods prices, this part of the index registered a 1.0 percent (a.r.) increase in February, and is up 0.7 percent (a.r.) over the past 3 month. The concern here is that goods prices may be reversing their recent tendency to fall.

Moving from the trees to the forest, the biggest unpleasant surprise is in the overall distribution of changes. A comprehensive look at the detail in this month's release shows that 70 percent of prices (measured by expenditure weight) rose by more than 3 percent. By comparison, in January 40 percent of prices increased more than 3 percent. So, regardless of how you measure it, the inflation trend has gone up and is now back to at least 2.75 percent.

This new inflation data clearly does not let the Federal Open Market Committee off the hook. Their federal funds rate target has been above most estimates of neutral since they raised it to 4.5 percent at the meeting chaired by Alan Greenspan on January 31, 2006. In intervening year, virtually no slack has developed in the national economy and the inflation trend has risen at least one-half of a percentage point.

So, what interest rate path do we need in order to get CPI inflation back down to 2 percent? I would think that simply maintaining the policy rate at its current level of 5.25 percent won't do the trick. We probably need another 50 basis points or so.

Consumer Price Inflation, Various Measures
(Through February 2007, all data s.a. at an annual rate)

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Detail for Computation of the Median CPI
February 2007
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Used cars and trucks	-5.7	1.7	1.7
Medical care commodities	-3.6	1.5	3.1
Motor vehicle insurance	-2.3	2.3	5.4
Fuel oil and other fuels	-1.9	0.3	5.7
Men's and boys' apparel	-1.9	0.9	6.6
New vehicles	-1.4	5.0	11.6
Tenants' and household insurance	-1.0	0.4	12.0
Recreation	-0.1	5.5	17.5
Miscellaneous personal services	0.3	1.2	18.7
Footwear	0.7	0.7	19.5
Lodging away from home	1.0	2.7	22.2
Communication	1.0	2.9	25.1
Miscellaneous personal goods	1.5	0.2	25.3
Household furnishings and operations	2.1	4.6	29.9
Personal care products	2.6	0.7	30.7
Dairy and related products	2.8	0.8	31.5
Nonalcoholic beverages and beverage materials	3.0	0.9	32.4
Personal care services	3.2	0.7	33.1
Owners' equivalent rent of primary residence	3.6	24.0	57.1
Motor vehicle fees	3.6	0.5	57.5
Other food at home	3.8	1.8	59.3
Motor fuel	4.2	4.5	63.8
Public transportation	4.3	1.1	64.9
Food away from home	4.4	6.0	70.9
Motor vehicle parts and equipment	4.5	0.4	71.3
Rent of primary residence	5.2	6.0	77.3
Meats, poultry, fish, and eggs	5.5	2.1	79.4
Water and sewer and trash collection services	6.3	0.9	80.3
Processed fruits and vegetables	6.5	0.3	80.6
Motor vehicle maintenance and repair	6.8	1.2	81.8
Education	7.2	3.1	84.9
Women's and girls' apparel	8.5	1.6	86.5
Alcoholic beverages	8.7	1.1	87.6
Medical care services	8.9	4.9	92.5
Infants' and toddlers' apparel	12.0	0.2	92.7
Tobacco and smoking products	12.6	0.7	93.4
Car and truck rental	14.1	0.1	93.5
Cereals and bakery products	14.3	1.1	94.6
Gas (piped) and electricity	19.4	4.1	98.7
Jewelry and watches	31.1	0.3	99.0
Fresh fruits and vegetables	94.9	1.0	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16 Percent Trimmed Mean
1 Month	4.5	2.9	3.6	3.6
3 Months	4.0	2.6	3.2	3.2
6 Months	0.1	2.2	3.3	2.4
12 Months	2.4	2.7	3.6	2.8
12 Months ended February 2006	3.6	2.1	2.4	2.5

Detail for Computation of the Median CPI