The Inflation Update: April 2003
Stephen G. Cecchetti
16 May 2002

 

My phone has been ringing continuously.  Journalists alternately want my views on who I think will be the next President of the Federal Reserve Bank of New York and what I think about the prospects for deflation.  Having now thought about both of these in some detail, I thought I would write down my answers so that I remember them.  Here they are.

 

I have no idea who will be the next President of the Federal Reserve Bank of New York.   What I do know is that whoever it is will have to serve constituencies inside the Federal Reserve System and inside the international financial community. And their primary task over the next decade will be to figure out how to best promote financial stability in the face of the changes in the structure of financial intermediation and the instruments used to transfer and manage risk.  This will require vision, technical expertise and political savvy.  Bill McDonough has these skills in abundance and he earned the respect on Wall Street and in Washington.  His successor must do the same. 

 

As for deflation, I have a number of general comments.  First, is a bit of central bank rhetoric. Observers have made quite a bit out of Chairman Greenspan’s statement that further disinflation would be unwelcome.  What went unsaid is that a sustained increase in inflation would be unwelcome as well.  The pursuit of price stability is symmetric.  Most central bankers have been clear about this – they are what we might refer to as “flation” averse. And price stability means that some prices are falling while others are rising. To see the point, think about a world with only two goods and so there are only two prices. I like Professor Baumol’s example of computers and Mozart quartets. The technology to produce computers is roaring along, while the Mozart quartet technology is stagnant.  If the average price level in this world is stable, then it must be that the price of computers is falling while the price of Mozart quartets is rising.  This is not deflation.  Making the example more realistic, we would say that all goods and services where either production costs are falling faster than average or demand is rising slower than average will have price declines.  But again, that’s not deflation.

 

Okay, so what about this morning’s numbers?  Well, the all-items CPI-U fell 3.8 percent at an annual rate (a.r.) for the month and is up 2.2 percent over the past 12 months.  Core measures also showed a decline, with the traditional CPI excluding food and energy and the median CPI computed by the Federal Reserve Bank of Cleveland both flat for the month.  Over the past year, these measures have shown increases of 1.5% and 2.3% respectively.

 

Some years ago, I tried to figure out how much noise there is in each measure of inflation.  That is, what is the normal range of deviation from the trend for each index we can reasonably expect to see without concluding that the trend has shifted up or down?  The first thing I learned was that it was best to look at 6-month changes.  Anything shorter is pretty much useless.  And then I concluded that the 6-month change in the headline index could easily be one percentage point from the trend in either direction.  Six-month changes in core measure cut that roughly in half.  Looking at the numbers released today, that means that we should think that the 0.9% (a.r.) reading on the CPI excluding food and energy suggests that trend inflation is not be above 1˝%, and could be as low as 0.4%.  Current estimates of the bias in the CPI are a hair under one percent, and so correctly measured inflation is right at zero.  As the Chairman said,  “substantial further disinflation would be an unwelcome development.”

 

The detail in the CPI report confirms that we are very close to price stability.  Owners' equivalent rent, one of the best indicators of things to come, was unchanged for the month, and is up 2.6% over the past year. Medical care prices rose a modest 2.5% (a.r.) in April, well below its 4% average for the last 12 months.  And core services (services excluding energy services) were up only 1.6% (a.r.) for the month, almost half its 12-month average rise of 2.9%.  Meanwhile core goods prices continued to fall and are now down 1.8% for the year. 

 

All of this will surely lead FOMC members to redouble their efforts to keep interest rates low for long enough to ensure inflation rises back over 2% and possibly even to 3%.  Isn’t it ironic that after spending years working to achieve price stability we decide that we don’t want it?

 

 

Consumer Price Inflation, Various Measures
(Through April 2003, all data s.a. at an annual rate)

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Detail for Computation of the Median CPI
April 2003
Component	Annualized 1-month % change	Relative Importance	Cumulative Relative Importance
Motor vehicle insurance	15.3	2.5	2.5
Nonalcoholic beverages and beverage materials	8.0	0.9	3.4
Meats, poultry, fish, and eggs	7.5	2.3	5.7
Education	6.6	2.9	8.6
Personal care products	6.4	0.7	9.3
Jewelry and watches	5.8	0.4	9.6
Personal care services	5.1	0.9	10.5
Water and sewer and trash collection services	4.2	0.9	11.4
Public transportation	4.2	1.2	12.6
Miscellaneous personal services	3.9	1.6	14.2
Rent of primary residence	3.6	6.5	20.7
Medical care services	3.2	4.6	25.3
Motor vehicle maintenance and repair	3.1	1.4	26.7
Motor vehicle fees	2.1	0.6	27.3
Tenants'  and household insurance	2.1	0.4	27.7
Lodging away from home	2.1	2.6	30.3
Tobacco and smoking products	1.8	0.9	31.2
Food away from home	0.7	6.3	37.5
Owners' equivalent rent of primary residence	0.0	22.4	59.9
Medical care commodities	-0.5	1.4	61.3
Recreation	-1.1	6.0	67.3
Alcoholic beverages	-1.3	1.0	68.3
Household furnishings and operations	-1.9	4.7	72.9
Motor vehicle parts and equipment	-2.2	0.4	73.4
Used cars and trucks	-3.2	2.1	75.4
Other food at home	-3.6	1.8	77.2
Miscellaneous personal goods	-3.8	0.2	77.4
New vehicles	-5.1	4.8	82.3
Women's and girls' apparel	-5.2	1.7	84.0
Gas (piped) and electricity	-5.6	3.7	87.6
Infants' and toddlers' apparel	-5.7	0.2	87.8
Cereals and bakery products	-5.8	1.3	89.1
Car and truck rental	-6.5	0.1	89.2
Dairy and related products	-8.9	0.9	90.1
Footwear	-9.7	0.8	90.9
Communication	-10.0	2.9	93.9
Men's and boys' apparel	-10.4	1.1	94.9
Processed fruits and vegetables	-15.7	0.3	95.2
Fresh fruits and vegetables	-16.6	0.9	96.2
Motor fuel	-64.2	3.6	99.7
Fuel oil and other fuels	-77.9	0.3	100.0