The Inflation Update

Last fall I noted that since 1999 rents had risen by less than 20% (cumulatively), while home purchase prices had increased more than 60% (for the country as a whole). Some of this could be explained by low interest rates, but not all. A reasonable estimate is that two-thirds of the gap has to be closed, either by rising rents, falling home prices, or a combination of the two. Well, this morning's inflation data suggest that at least some of it will come in the form of rent increases. Owner-equivalent rent increased by a startling 5.3% at an annual rate in March, double its recent readings.

Looking at the headline and core measures, we see the impact of this acceleration in rental prices. First, the headline CPI rose 4.3% (a.r.) in the month, and is up 3.4% (a.r.) Beyond that, there are there is the jump in core inflation, with the traditional CPI excluding food and energy up 4.2% (a.r.) for the month! This is the highest reading since June 2001. Meanwhile, the Median CPI computed by the Federal Reserve Bank of Cleveland rose by an outsized 5.0% (a.r.). All of these are well above recent trends.

Returning to the detail in the report, core goods (commodities excluding food and energy commodities) rose substantially as well, showing a 3.5% (a.r.) increase for the month. And led by OER, core services (excluding energy services) increased 4.1% (a.r.) in March. All of these numbers are well above what we have seen for some time. One possibility is that energy price increases are finding their way into other prices. When costs rise, margins can only shrink so much before prices start to rise.

As for housing, my guess is that rental increases will be with us for a while and the impact on overall inflation will be sizeable. The following quick calculations suggests how big. In recent years, traditional core inflation has been around 2%, with OER running about 2.5%. Conservatively, we could assume that trend in rents goes up by one-and-one-half percentage points to 4%. Since OER is one-third of the CPI excluding food and energy, this would drive the trend up to 2.5%. And that's a conservative estimate. (I will simply note that the impact of this on the PCE chained index is about half this size -- that is, it would take a three percentage point increase in rent price inflation to drive PCE inflation up one-half-of-one percent.)

So, what's the bottom line for policymakers? At this point, they have good reason to be nervous. Normally, interest rate changes affect inflation at a lag of 18 to 24 months. That means that we should be starting to see the impact of 2004 increases about now, and will continue to see them for another 2 years. But is 5% high enough to keep inflation in check? My guess is that it is close. But, as the March statement says "the Committee will respond to changes in economic prospects as needed to foster these objectives."

Consumer Price Inflation, Various Measures
(Through March 2006, 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

Detail for Computation of the Median CPI
March 2006
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Fresh fruits and vegetables	-24.3	1.0	1.0
Gas (piped) and electricity	-12.7	4.2	5.2
Jewelry and watches	-9.9	0.3	5.5
Public transportation	-3.7	1.1	6.6
Personal care products	-3.0	0.7	7.3
Miscellaneous personal goods	-2.7	0.2	7.5
Water and sewer and trash collection services	-2.6	0.9	8.4
Infants' and toddlers' apparel	-2.0	0.2	8.6
Communication	-1.4	3.1	11.7
Processed fruits and vegetables	-1.0	0.3	12.0
New vehicles	-0.9	5.2	17.1
Tenants' and household insurance	0.0	0.4	17.5
Motor vehicle fees	0.0	0.5	18.0
Dairy and related products	0.7	0.9	18.9
Motor vehicle insurance	0.7	2.3	21.2
Household furnishings and operations	1.0	4.8	25.9
Other food at home	1.4	1.8	27.7
Food away from home	2.5	6.0	33.7
Cereals and bakery products	3.5	1.1	34.8
Personal care services	3.5	0.7	35.5
Alcoholic beverages	3.7	1.1	36.6
Meats, poultry, fish, and eggs	4.0	2.1	38.8
Motor vehicle maintenance and repair	4.0	1.1	39.9
Used cars and trucks	4.4	1.8	41.7
Fuel oil and other fuels	4.4	0.3	42.0
Recreation	4.4	5.7	47.7
Footwear	5.0	0.8	48.5
Rent of primary residence	5.0	5.9	54.3
Medical care commodities	5.2	1.5	55.8
Owners' equivalent rent of primary residence	5.3	23.7	79.5
Medical care services	5.3	4.8	84.3
Motor vehicle parts and equipment	5.3	0.4	84.6
Miscellaneous personal services	5.6	1.2	85.8
Car and truck rental	5.6	0.1	85.9
Education	6.2	3.0	88.9
Men's and boys' apparel	6.5	0.9	89.8
Tobacco and smoking products	7.5	0.7	90.5
Nonalcoholic beverages and beverage materials	8.5	0.9	91.5
Lodging away from home	10.3	2.7	94.1
Women's and girls' apparel	30.1	1.6	95.7
Motor fuel	52.4	4.3	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16% Trimmed Mean
1 Month	4.3	4.2	5.0	3.7
3 Months	4.3	2.8	3.7	3.1
6 Months	1.2	2.7	3.1	2.6
12 Months	3.4	2.1	2.7	2.6
12 Months ended March 2005	3.1	2.3	2.3	2.3

Detail for Computation of the Median CPI