The Inflation Update

This morning's CPI report confirms many people's worst fears. Inflation is up. The all items CPI rose 5.5% at an annual rate for the month of May, and is up 4.2% since May 2005. This is well above recent (or acceptable) trends. Core measures faired little better, with the CPI excluding food and energy up 3.6% (a.r.) in May, and 2.4% over the past 12 months. The Median CPI computed by the Federal Reserve Bank of Cleveland increased 4.3% (a.r.) for the month, and is up 2.7% for the year. Importantly, the trends in all of these numbers are up.

This time around, the detail of the report is worse than the headline numbers. Core goods prices (commodities excluding food and energy commodities) increased 0.9% (a.r.), while core services (services excluding energy services) were up 5.1%. Looking over the past 6 month, core goods prices are rising at a 1% rate, while services are going up at a 4% rate. This leads me to conclude that the inflation trend is now slightly above 3%.

Rising at 6.8% annual rate, owner equivalent is well above the 3.6% average for the traditional core. Some people have used this to discounted some of the inflation increase this month. There have even been suggestions that if it weren't for this strange way we have decided to measure owner-occupied housing prices, inflation would be quite a bit lower.

The problem with this reasoning is that the increase is quite broad based. Over 40 percent of the consumption basket experienced inflation in excess of 5%.

As for OER itself, I firmly believe that some measure of the cost of owner-occupied housing belongs in the price index used for monetary policy purposes. We should not just get rid of it. Furthermore, looking at these data, there are two choices: Either the OER distorts the CPI, or it doesn't. If it does, then along with claiming that measured inflation is currently too high, you have to accept that measured inflation from 2001 to 2004 was too low. That is, there was never a deflation scare. Instead, policy was much too loose following the end of the 2001 recession. That's what I think, but I doubt that Chairman Bernanke does.

The implications for monetary policy are pretty clear. With inflation at 3%, one percentage point above the 2% implicit target of the FOMC, we can now expect the federal funds rate to rise to at least 6%. But the risk is that it will not stop there. I could easily see the inflation trend rising to 3.5% over the next 6 months, and then the federal funds rate will have to go much higher.

Consumer Price Inflation, Various Measures
(Through May 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
May 2006
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Car and truck rental	-26.9	0.1	0.1
Fresh fruits and vegetables	-11.2	1.0	1.1
Men's and boys' apparel	-10.9	0.9	2.0
Gas (piped) and electricity	-7.0	4.1	6.0
Dairy and related products	-6.4	0.8	6.9
Meats, poultry, fish, and eggs	-5.6	2.1	9.0
Communication	-4.2	3.1	12.1
New vehicles	-3.4	5.1	17.2
Personal care products	-3.1	0.7	17.9
Tobacco and smoking products	-1.4	0.7	18.6
Motor vehicle fees	0.0	0.5	19.1
Lodging away from home	0.9	2.7	21.8
Tenants' and household insurance	1.0	0.4	22.1
Personal care services	1.2	0.7	22.8
Miscellaneous personal goods	1.4	0.2	23.0
Motor vehicle insurance	1.5	2.3	25.3
Women's and girls' apparel	2.2	1.6	26.9
Recreation	2.2	5.6	32.5
Miscellaneous personal services	3.5	1.2	33.7
Water and sewer and trash collection services	3.6	0.9	34.6
Rent of primary residence	3.8	5.9	40.5
Medical care services	4.2	4.8	45.3
Alcoholic beverages	4.3	1.1	46.4
Medical care commodities	4.3	1.5	47.8
Food away from home	4.3	6.0	53.8
Used cars and trucks	4.4	1.8	55.6
Footwear	4.9	0.8	56.4
Cereals and bakery products	5.3	1.1	57.5
Household furnishings and operations	5.8	4.7	62.2
Education	6.2	3.0	65.2
Motor vehicle maintenance and repair	6.3	1.1	66.4
Nonalcoholic beverages and beverage materials	6.8	0.9	67.3
Owners' equivalent rent of primary residence	6.8	23.6	90.9
Other food at home	8.9	1.8	92.7
Infants' and toddlers' apparel	9.7	0.2	92.8
Public transportation	13.0	1.1	93.9
Motor vehicle parts and equipment	13.2	0.4	94.3
Processed fruits and vegetables	13.6	0.3	94.5
Jewelry and watches	24.9	0.3	94.9
Fuel oil and other fuels	42.3	0.3	95.2
Motor fuel	78.6	4.8	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16% Trimmed Mean
1 Month	5.5	3.6	4.3	3.7
3 Months	5.7	3.8	4.2	3.4
6 Months	4.2	2.9	3.6	2.9
12 Months	4.2	2.4	3.0	2.7
12 Months ended May 2005	2.8	2.2	2.3	2.3

Detail for Computation of the Median CPI