The Inflation Update

The June CPI excluding food and energy rose 3.6 percent at an annual rate (a.r.), half again as much as the 2.4 percent (a.r.) rise in the headline CPI. And the median CPI computed by the Federal Reserve Bank of Cleveland fared even worse, rising by a whopping 4.6 percent (a.r.) for the month. With four months of consistently high numbers, it has become impossible to dismiss this as an aberration. Trend inflation is now over 3 percent.

Here's how I come to this conclusion: Start by splitting the traditional core into goods and services. Commodities excluding food and energy commodities rose 0.9 percent (a.r.) in June, while services excluding energy service increased 4.5 percent (a.r.). But these are one month changes, so let's look at something a bit less volatile. Over the past 6 months, these two measures are up 1.1 percent (a.r.) and 4.0 percent (a.r.) respectively. My rule of thumb is that trend inflation is 1/4 times core goods inflation plus 3/4 times core service inflation: (1/4 x 1) + (3/4 x 4) = 3.25. And even this estimate may be optimistic.

To see why inflation is so high, notice two things. First, there is the fact that so many price changes are above 3 percent this time. Linsey Molloy of the Federal Reserve Bank of Cleveland computes these price-change distributions for me every month, and for some time now they have been extremely interesting to look at as they allow us to see how broad-based inflation changes are. Here's what I learned this time: At the beginning of the year, around 40 percent of CPI prices (by weight) increased by 3 percent or more. Last number, it was over 75 percent, and this month it is 60. To put it bluntly, 3 percent inflation is a broad phenomenon.

My second point will not surprise regular readers of this update. Owner equivalent rent (OER), which rose a staggering 5.2 percent (a.r.) in June. While energy price changes tend to create month-to-month fluctuations, OER is a six-month moving average, so it turns around very slowly. As I have said before, I expect it to continue to rise at a rate of 4 to 5 percent for some time.

Increasing inflation, combined with a slowing in the housing market, put Chairman Bernanke and his FOMC colleagues in something of a bind. If they focus on inflation, as many Committee members are likely to want (and I think they should), then trend inflation of 3.25 percent would require further increases in the target federal funds rate. As policymakers know, for each percentage point of inflation above their (implicit) objective they need to raise interest rates by 1.5 percent. With neutral at about 4.5 percent, and the objective around 2, that means that the funds rate needs to be at between 6.25 and 6.5 percent. To the extent that growth slows below potential, this number will be lower, and inflation rises above 3.25 percent ... well, the math isn't all that complicated.

(A Note: I'm trying to adopt a more European attitude toward August, so I will be on vacation for the next CPI release.)

Consumer Price Inflation, Various Measures
(Through June 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
June 2006
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Gas (piped) and electricity	-12.5	4.0	4.0
Motor fuel	-11.3	5.0	9.0
Footwear	-9.2	0.8	9.8
Car and truck rental	-7.7	0.1	9.9
Infants' and toddlers' apparel	-6.0	0.2	10.1
Men's and boys' apparel	-4.1	0.9	11.0
Motor vehicle insurance	-1.4	2.3	13.2
Medical care commodities	-1.3	1.5	14.7
New vehicles	-0.9	5.1	19.8
Household furnishings and operations	0.0	4.7	24.5
Motor vehicle parts and equipment	0.0	0.4	24.9
Motor vehicle fees	0.9	0.5	25.4
Tenants' and household insurance	1.0	0.4	25.7
Recreation	1.1	5.6	31.4
Dairy and related products	1.3	0.8	32.2
Other food at home	1.4	1.8	34.0
Communication	1.4	3.0	37.0
Nonalcoholic beverages and beverage materials	1.6	0.9	37.9
Processed fruits and vegetables	2.0	0.3	38.2
Personal care services	2.3	0.7	38.8
Miscellaneous personal goods	2.8	0.2	39.0
Motor vehicle maintenance and repair	2.8	1.1	40.2
Food away from home	3.1	6.0	46.2
Cereals and bakery products	3.5	1.1	47.2
Lodging away from home	3.6	2.6	49.9
Medical care services	4.6	4.8	54.7
Meats, poultry, fish, and eggs	4.6	2.1	56.8
Miscellaneous personal services	4.7	1.2	58.0
Personal care products	4.8	0.7	58.7
Alcoholic beverages	4.9	1.1	59.8
Owners' equivalent rent of primary residence	5.2	23.6	83.4
Used cars and trucks	5.2	1.8	85.2
Rent of primary residence	5.5	5.9	91.1
Women's and girls' apparel	5.5	1.6	92.7
Education	6.1	3.0	95.7
Water and sewer and trash collection services	6.4	0.9	96.6
Jewelry and watches	9.6	0.3	96.9
Tobacco and smoking products	9.7	0.7	97.6
Public transportation	15.9	1.1	98.7
Fuel oil and other fuels	18.0	0.3	99.0
Fresh fruits and vegetables	19.7	1.0	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16% Trimmed Mean
1 Month	2.4	3.6	4.6	2.8
3 Months	5.1	3.6	4.1	3.0
6 Months	4.7	3.2	3.9	3.1
12 Months	4.3	2.6	3.2	2.9
12 Months ended June 2005	2.5	2.0	2.3	2.0

Detail for Computation of the Median CPI