The Inflation Update

Well, I guess I could have been more wrong, but I'm not sure how. For some time I've expected inflation to rise, and it has been stable. Now, there are increasing signs that the inflation trend is actually falling. It is dangerous to make too much of one month's numbers, but the evidence is accumulating that the CPI trend may from its current level of 2.5 percent to something closer to 2 percent.

Let's start with the overall numbers: This morning's report shows a headline CPI increase of 7.6 percent at an annual rate (a.r.). But this extremely high reading is the result of a 6 percent increase in energy prices for the month. If energy prices were to sustain this rate for 12 continuous months, they would double. And removing just energy prices brings the one-month inflation number down to 1.1 percent (a.r.) Given this, I had expected core readings to be very low; instead they are mixed. While the conventional CPI excluding food and energy rose an extremely modest 0.7 percent (a.r.), the median CPI and the 16 percent trimmed mean CPI, both computed by the Federal Reserve Bank of Cleveland, were up was 3.3 and 3.2 percent respectively.

The detail of the release lead me to think that the median CPI (and it's trimmed mean cousin) are misrepresenting the true state of inflation affairs. First, the 10 percent (a.r.) January spike in medical care prices looks to be a complete aberration. In March, medical care commodity prices fell at a -3.7 percent annual rate, while services rose a very most 2.5 percent (a.r.). Over the past 6 months, overall medical care prices are up a very modest 4.2 percent.

But the real new is in Owner Equivalent Rent (OER). For over a year I have been arguing that OER will have to shoot up to close the gap between the price of homeownership and the cost of renting. My sense was that if even half of that gap were closed by rents rising it would add as much as one full percentage point to the CPI for three to four years. Well, it doesn't look like it's going to happen. There may be something wrong with my logic, something wrong with the indices measuring constant quality housing prices, or something wrong with OER itself. I willing to accept that the first of these is the most likely, and that OER inflation is going to remain in the 3 to 4 percent range for the foreseeable future.

Next there is food away from home. A combination of goods and services, this index normally provides a good sense of the inflation trend. This month, food away from home rose 1.0 percent at an annual rate, well below it's recent readings that were between 3.5 and 4.0 percent.

Looking at core goods and services prices (that's commodities excluding food and energy commodities and services excluding energy services) we can get a sense of what all of this means. Core goods prices are falling slightly, as they have been off and on for much of the past 5 years, while core services prices are rising at a rate of roughly 3 percent. Taken together, that means the inflation trend is headed down toward 2 percent.

It looks as if the Federal Open Market Committee's bet is going to pay off (and mine is not). A federal funds rate target of 5.25 percent looks like it was enough to bring inflation back to a level that we all find palatable. And it has done it much faster than the Fed's public forecasts suggested that it would. (Did the internal forecasts show a faster decline? We'll know in 5 years.) Instead of expecting further rate increases, now we will wait a few months to ensure the permanence of these inflation gains, and then the funds rate can slowly fall back to neutral.

Consumer Price Inflation, Various Measures
(Through March 2007, 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 2007
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Lodging away from home	-24.3	2.7	2.7
Jewelry and watches	-22.0	0.3	3.0
Fresh fruits and vegetables	-19.1	1.0	4.0
Car and truck rental	-17.4	0.1	4.1
Women's and girls' apparel	-15.2	1.6	5.7
Footwear	-7.5	0.7	6.5
Men's and boys' apparel	-7.4	0.9	7.4
Medical care commodities	-3.7	1.4	8.8
Cereals and bakery products	-3.0	1.1	9.9
Motor vehicle insurance	-2.9	2.2	12.2
Miscellaneous personal goods	-2.2	0.2	12.4
Used cars and trucks	-1.9	1.7	14.0
Processed fruits and vegetables	-0.9	0.3	14.3
Recreation	-0.3	5.5	19.8
Tenants' and household insurance	0.1	0.4	20.2
Miscellaneous personal services	0.8	1.2	21.4
Food away from home	1.0	6.0	27.4
Public transportation	1.2	1.1	28.5
Infants' and toddlers' apparel	1.8	0.2	28.7
Household furnishings and operations	2.3	4.6	33.3
Motor vehicle fees	2.5	0.5	33.8
Tobacco and smoking products	2.5	0.8	34.6
Medical care services	2.5	4.9	39.5
Personal care services	2.7	0.7	40.1
Motor vehicle parts and equipment	2.9	0.4	40.5
Other food at home	2.9	1.8	42.3
Owners' equivalent rent of primary residence	3.3	24.0	66.2
New vehicles	3.6	5.0	71.2
Water and sewer and trash collection services	3.9	0.9	72.1
Communication	4.1	2.9	75.0
Rent of primary residence	4.2	6.0	81.0
Personal care products	4.3	0.7	81.7
Motor vehicle maintenance and repair	4.8	1.2	82.9
Education	7.2	3.1	86.0
Alcoholic beverages	7.8	1.1	87.1
Meats, poultry, fish, and eggs	14.1	2.1	89.3
Gas (piped) and electricity	16.4	4.2	93.4
Dairy and related products	16.9	0.8	94.2
Nonalcoholic beverages and beverage materials	22.5	0.9	95.2
Fuel oil and other fuels	50.5	0.3	95.5
Motor fuel	233.5	4.5	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16 Percent Trimmed Mean
1 Month	7.6	0.7	3.3	3.2
3 Months	4.7	2.3	3.1	3.3
6 Months	2.4	1.9	3.2	2.5
12 Months	2.8	2.6	3.5	2.8
12 Months ended March 2006	3.4	2.1	2.6	2.6

Detail for Computation of the Median CPI