The Inflation Update: April 2006
Stephen G. Cecchetti
17 May 2006

Waltham , Massachusetts

In this morning's New York Times is the following headline: " Wholesale Prices and Housing Data Cool Inflation Worry."  The story notes that the Producer Price Index excluding food and energy rose very modestly last month (less than expected) and that for the third straight month housing starts had declined.  Unfortunately, the PPI is an extremely poor predictor of inflation at the retail level and this morning’s CPI report is a clear reminder of that. And second, the fact that the housing sector is in trouble (which it clearly is) will have a big impact on growth and very little downward impact on measured inflation. In fact, it could be the reverse, putting upward pressure on rents, which feed directly into the CPI.

So, what is in this morning's Consumer Price data?  Well, my headline would not use the word "cool" to describe inflation.  The BLS reported that the all-items CPI rose 7.5% at an annual rate (a.r.) between March to April.  The month's 58% (a.r.) energy price increase was obviously a big part of this, but the core inflation measures are up, too, indicating that retail price pressures aren’t just about oil any longer. The traditional CPI excluding food and energy rose 3.6% (a.r.) last month which, while less than last month's 4.2% (a.r.) rise, is well above recent trends.  And the Federal Reserve Bank of Cleveland's Median CPI rose 3.3% (a.r.).  Inflation, by virtually every measure, is up.

The detail of the report confirms my fears. Core good prices (commodities excluding food and energy commodities) rose 0.9% (a.r.), roughly their recent trend, but core services prices (services excluding energy services) increased 4.0% (a.r.) for the month.  This latter measure is dominated by owner equivalent rent, which was up 4.7% for the month. In the March data we only had the one month's “elevated” numbers, so there was nothing to get too worried about.  Now we have two.  My guess is that this time next month we will have three. 

All of this leads me to conclude that the inflation trend has risen to around 3% (or more). Remember a good rule-of-thumb is that the trend is roughly 0.7 times core service price inflation plus 0.3 times core goods price inflation.  Core services are 40% OER, and are now rising at a 4% rate. Rent increases are really starting to bite!  Meanwhile, some combination of transportation cost increases and dollar depreciation seem to be driving core goods price up at a roughly 1% rate:  0.7x4 + 0.3x1=3.1%.  It's time to get worried.

As I have emphasized in the past, US inflation is unusual in that it treats renters and owners symmetrically using surveys infer the rents homeowners would pay if they were to rent the houses from themselves. This treatment of housing makes a huge difference.  In past updates I have noted that if OER were replaced by a home price index it would have increased our estimate of inflation significantly -- more than 1 percentage point per year on the CPI.  The flip side of this is that if we were to adopt the European standard, and ignore owner occupied housing in the construction of our consumer price measures, our inflation estimates would have been 0.5 percentage points lower. 

While Chairman Bernanke and his FOMC colleagues can take a few minutes to debate the finer points of how housing should be treated in inflation measurement, in the end they need to make interest rate policy.  Where do these data leave them? Inflation is definitely rising. Meanwhile, faltering growth is only a possibility.  Add to that the fact that rate changes influence growth much more quickly than they affect inflation, and I conclude that higher interest rates are in our future. Whether the Committee moves in June or August all depends on the data that comes in over the next 6 weeks.   But the data we’ve seen since the FOMC convened a week ago provides very little comfort to the committee.

Consumer Price Inflation, Various Measures
(Through April 2006, all data s.a. at an annual rate)

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