The Inflation Update

This morning's data is more good news for the Federal Open Market Committee and for all of us who are hoping that there is a low cost way of bringing Consumer Price inflation back down to 2 percent. While the one-month change in the all-items CPI was 5.1 percent at an annual rate (a.r.), core measures were substantially more subdued. The conventional CPI excluding food and energy rose 2.1 percent (a.r.) in April, and is now up 2.3 percent for the past 12 months. The Median CPI computed by the Federal Reserve Bank of Cleveland increased an identical 2.1 percent (a.r.) this month, well below it's 12-month average of 3.4 percent.

The good news persists throughout the report. Core goods prices (commodities excluding food and energy commodities) fell by 1.5 percent (a.r.), and are down 0.5 percent since April of 2006. Meanwhile core services prices (services excluding energy services) increased 3.6 percent (a.r.) this month, very slightly above the 3.5 percent increase over the past 12 months.

My favorite indicator of the medium-term inflation trend, owner equivalent rent (OER), continued to moderate, rising a mere 2.1 percent (a.r.) for the month – well below it's recent readings that have been in excess of 4 percent. Regular readers of this update may recall last year when I was warning that rises in OER would eventually push core inflation over 3 percent. Well, that hasn't happened and I have a theory about where I went wrong. At the time, my logic went like this: Over the past 5 years, resale prices of houses have risen far faster than rents, opening up a significant gap between the two. My sense was that house prices were likely to languish, perhaps even fall modestly, so that the lion's share of the gap would be closed by a step-up in the rise of rents. What I failed to see was that the combination of a high inventory of unsold new homes, combined with increased mortgage defaults could flood the rental market. It is the glut of rental houses that is holding OER down now and is likely to continue to do so in the foreseeable future. The result will be falling CPI inflation.

What does this all mean for monetary policy? Well, this morning's news carried a story with the following lead: "Federal Reserve Chairman Ben S. Bernanke's inflation concerns have prompted investors to make a record bet against $88.8 billion of two-year Treasuries." The thrust of the column was that the FOMC's inflation concerns were driving traders to bet that interest rates would rise; rising interest rates mean falling bond prices, something that a seller of a Treasury note futures contract will benefit from.

As a teacher of finance and economics (and author of a textbook), what fascinated me most about this story was that the author seems to have forgotten that every futures contract has two sides to it. For every seller, there must be a buyer. The $88.8 billion is the quantity outstanding – what's called the open interest. The story could just as easily focused on the fact that traders were placing a record bet that interest rates would fall and prices rise; that's what the buyers of these contracts are hoping for. Regardless of the sloppy financial journalism, there is something interest going on here: The high level of open interest in two-year Treasury note futures suggests that market participants are as uncertain as ever. While one sizeable group thinks that the next FOMC move will be up, another, equally large group thinks that the next move is likely to be down.

What side of this bet would I take? (For the record, I have not placed a bet.) Well, spending more than a year arguing that interest rates needed to rise from their current 5.25 percent level, I now think that the next move will most likely be down. With inflation abating, and both current and potential growth slowing, there is no need for further rate increases. The only question is: When will the cuts start?

Consumer Price Inflation, Various Measures
(Through April 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
April 2007
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Car and truck rental	-26.8	0.1	0.1
Infants' and toddlers' apparel	-20.7	0.2	0.3
Nonalcoholic beverages and beverage materials	-8.9	0.9	1.2
Jewelry and watches	-6.8	0.3	1.5
Footwear	-5.6	0.7	2.2
Women's and girls' apparel	-5.5	1.6	3.8
Processed fruits and vegetables	-5.3	0.3	4.1
Tobacco and smoking products	-5.0	0.7	4.8
Public transportation	-4.7	1.1	5.9
Household furnishings and operations	-3.1	4.6	10.5
Gas (piped) and electricity	-3.0	4.2	14.7
Motor vehicle insurance	-1.0	2.2	16.9
Used cars and trucks	-0.2	1.7	18.6
New vehicles	0.3	4.9	23.5
Personal care products	0.5	0.7	24.3
Recreation	0.7	5.5	29.7
Communication	1.2	2.9	32.7
Motor vehicle fees	1.3	0.5	33.2
Personal care services	1.6	0.7	33.8
Owners' equivalent rent of primary residence	2.1	23.9	57.7
Motor vehicle parts and equipment	2.3	0.4	58.1
Tenants' and household insurance	2.3	0.4	58.4
Rent of primary residence	3.0	6.0	64.4
Alcoholic beverages	3.0	1.1	65.5
Water and sewer and trash collection services	3.2	0.9	66.4
Motor vehicle maintenance and repair	3.4	1.2	67.6
Food away from home	3.8	6.0	73.6
Fresh fruits and vegetables	3.9	1.0	74.6
Medical care services	4.5	4.9	79.5
Miscellaneous personal goods	5.2	0.2	79.7
Medical care commodities	5.5	1.4	81.1
Education	5.5	3.1	84.2
Dairy and related products	5.6	0.8	85.0
Other food at home	6.5	1.7	86.8
Men's and boys' apparel	6.9	0.9	87.7
Miscellaneous personal services	9.2	1.2	88.8
Cereals and bakery products	10.8	1.1	90.0
Meats, poultry, fish, and eggs	11.3	2.1	92.1
Lodging away from home	25.7	2.6	94.7
Fuel oil and other fuels	28.2	0.3	95.0
Motor fuel	74.3	5.0	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16 Percent Trimmed Mean
1 Month	5.1	2.1	2.1	2.5
3 Months	5.7	1.9	3.0	3.1
6 Months	4.2	2.0	3.0	2.8
12 Months	2.6	2.3	3.4	2.8
12 Months ended April 2006	3.5	2.3	2.7	2.5

Detail for Computation of the Median CPI