The Inflation Update

I didn't feel like cooking dinner last night, so we ordered pizza. When my wife called to order, she discovered that the menu had changed: the sizes were no longer the same. As we sat eating a half hour later, I asked what she thought had happened. Her immediate response was that the restaurant had raised their prices. A quick look at the new takeout menu confirmed that she was right.

It is always important to be weary of using personal anecdotes as evidence of anything (besides personal experience). And when it comes to inflation, I am always extremely hesitant to do this. Memories play tricks. People are more likely to remember price increases that hurt them than decreases that benefit them. But this morning's CPI report validated last night's personal experience: food away from home (eg. the price of my pizza dinner) rose 5.3% at an annual rate last month. That's one of the biggest increases since 1990!

Okay, you're saying, but what about the overall inflation? Surely that hasn't jumped by as much. Unless you went on vacation - prices of car rentals, gasoline, hotel stays, and restaurants are all up dramatically - the news is not all that bad. In fact, inflation outside the restaurant business seems to have taken something of a rest last month.

This morning the BLS announced that the all-items CPI fell very slightly for the month of July, dropping -0.6% (a.r.). Core measures showed some deceleration as well, with the CPI excluding food and energy up 1.2% (a.r.) for the month, and the Median CPI computed by the Federal Reserve Bank of Cleveland rose a very modest 1.6% (a.r.). Over the past 12 months, the all-items CPI is up 3%, while the two core measures have risen 1.8% and 2.4% respectively.

The detail of the report gives me little reason to be optimistic. Core goods prices fell -3.3% (a.r.) for the month, while core services rose 3.2% (a.r.). The core goods price decline can be traced to declines in volatile apparel prices (likely to be reversed) and new car prices. The core service price increase is very wide spread, and so is clear cause for concern. In fact, without the recent increases in energy prices, which tend to depress owner equivalent rent, things would have been much worse. This looks like a temporary rest, not a new lower trend.

Okay, so what does this all mean for the FOMC and interest rates? To paraphrase recent statements, this is likely to make the pace more measured. Low inflation, the economy's poor employment growth record, and the coming election, are all arguments for slowing down. This is the argument that I believe will carry the day at the September 21 meeting.

My views are different. At 1% the federal funds rate is probably 2 percentage points below equilibrium. To get a rough idea how expansionary that is, we can use a simple Taylor rule. If the inflation is around the FOMC's implicit target, then this level of the interest rate could only be justified if the output gap were 5% more than 3 times the current estimate! Either the FOMC understands something fundamental that I don't, or more inflation is on the way.

Consumer Price Inflation, Various Measures
(Through July 2004, all data s.a. at an annual rate)

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Detail for Computation of the Median CPI
July 2004
Component	Annualized 1-month % change	Relative Importance	Cumulative Relative Importance
Motor fuel	-38.7	4.2	4.2
Footwear	-19.2	0.8	4.9
Women's and girls' apparel	-11.9	1.7	6.6
New vehicles	-7.6	4.8	11.4
Dairy and related products	-7.3	0.9	12.3
Fresh fruits and vegetables	-6.1	0.9	13.2
Communication	-4.1	3.0	16.2
Household furnishings and operations	-3.8	4.4	20.7
Personal care products	-3.1	0.6	21.3
Recreation	-2.2	5.8	27.1
Miscellaneous personal goods	-1.4	0.2	27.3
Alcoholic beverages	-1.2	1.0	28.3
Tenants' and household insurance	-1.0	0.4	28.7
Jewelry and watches	-0.9	0.3	29.0
Medical care commodities	-0.4	1.5	30.5
Men's and boys' apparel	0.0	1.0	31.5
Cereals and bakery products	1.2	1.2	32.7
Owners' equivalent rent of primary residence	1.6	23.4	56.1
Other food at home	2.2	1.8	57.8
Gas (piped) and electricity	2.4	3.7	61.6
Rent of primary residence	2.9	6.2	67.7
Miscellaneous personal services	3.3	1.5	69.2
Nonalcoholic beverages and beverage materials	3.5	0.9	70.1
Personal care services	3.7	0.6	70.7
Motor vehicle insurance	3.8	2.5	73.2
Public transportation	4.7	1.0	74.2
Motor vehicle maintenance and repair	4.9	1.3	75.6
Medical care services	5.0	4.7	80.2
Education	5.1	2.9	83.2
Infants' and toddlers' apparel	5.2	0.2	83.3
Food away from home	5.3	6.1	89.5
Motor vehicle parts and equipment	6.9	0.4	89.8
Water and sewer and trash collection services	7.0	0.9	90.8
Meats, poultry, fish, and eggs	9.6	2.3	93.1
Motor vehicle fees	10.6	0.5	93.6
Tobacco and smoking products	12.0	0.8	94.4
Lodging away from home	14.2	3.0	97.4
Processed fruits and vegetables	14.4	0.3	97.7
Used cars and trucks	14.7	2.0	99.6
Fuel oil and other fuels	42.6	0.3	99.9
Car and truck rental	74.0	0.1	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI
1 Month	-0.6	1.2	1.6
3 Months	3.7	1.6	2.2
6 Months	3.8	2.5	2.8
12 Months	3.0	1.8	2.4
12 Months ended July 2003	2.1	1.5	2.2

Detail for Computation of the Median CPI