The Inflation Update

To start with the conclusion: Yesterday I thought that a September interest-rate cut was very unlikely, and today's data has not changed my view. Looking at the numbers, we see that the all-items CPI moderated significantly, rising only 1.7 percent at an annual rate (a.r.) for the month, and is now up 2.4 percent since July 2006. Core measures continued to suggest declining inflation. While the traditional CPI excluding food and energy up 2.9 percent (a.r.) in July, well above it's 12-month change of 2.2 percent, more stable alternatives were much less worrisome. The Federal Reserve Bank of Cleveland core-inflation measures, the Median CPI and 16 percent trimmed mean, rose a modest 2.0 (a.r.) and 1.8 (a.r.) for the month and continue to show a clear downward trend.

The details in this morning's report lead to some minor concerns; but they are really very minor. While core service prices (services excluding energy services) rose 3.3 percent (a.r.), exactly equal to their 12-month average level, core goods prices reversed their cumulative decline of the past three months, rising 1.1 percent (a.r.). This represents an increase from a few months ago. But looking at the detail, we can isolate the like source of this spike. Specifically, there was a large rise in the prices of footwear and men's apparel, both of which registered annual rate increases of between 15 and 20 percent for the month. Removing these two items (which account for 7.5 percent of core goods) completely eliminates the 1.1 percent (a.r.) rise. Are we finally seeing some exchange rate pass-through in the form of higher clothing prices? Given the volatility in these series, it is extremely hard to say whether the July numbers represent new trends. We will have to wait and see. But in the meantime, I'm planning on staying focused on the 16 percent trimmed mean CPI which suggests that the inflation trend is falling toward 2 percent.

What this means for policy is pretty clear (at least to me): Interest rates will likely stay were they are for now, with a cut coming late this fall or early next winter.

As the FOMC said last Tuesday, their primary concern is inflation. Bringing inflation down means keeping the federal funds rate above its neutral level. Some people have speculated that the recent tightening in financial conditions -- reduced credit availability and increased risk spreads -- are likely to prompt a cut in the funds rate in the early fall. In my view, this reasoning fails to acknowledge that much of what has happened in the last few weeks is that credit conditions have gone back to normal. Put another way, the tightening of financial conditions that the FOMC was trying to precipitate with a federal funds rate above neutral has finally come to pass. I do expect hat FOMC to remain vigilant until it is clear that the CPI trend has come down to 2 percent, something that will take at least a few more months.

Finally, I would be remiss if I failed to mentiong the extraordinary events of the past week. The actions by both the Fed and the ECB (described and explained in my essay "Federal Reserve policy actions August 2007 - Frequently Asked Question" posted at www.voxeu.com/index.php?q=node/466) were some of the biggest in history. After several days of sleuthing my conclusion is that these were all about making sure there were sufficient funds for market to operate. It takes a combination of cash and market-makers for people to buy and sell securities. What the central banks did was put the cash into the banking system in order to ensure that markets would continue to operate normally. Interest rate cuts, a policy change aimed at stabilizing medium run inflation and growth, would not have helped and should not be expected. It is only when inflation falls convincingly that we can expect to see the federal funds rate come down.

Consumer Price Inflation, Various Measures
(Through July 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
July 2007
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Motor fuel	-18.6	5.6	5.6
Fresh fruits and vegetables	-15.6	1.0	6.6
Infants' and toddlers' apparel	-10.7	0.2	6.7
Jewelry and watches	-7.3	0.3	7.1
Gas (piped) and electricity	-5.7	4.1	11.2
Tenants' and household insurance	-5.3	0.4	11.5
Meats, poultry, fish, and eggs	-4.7	2.2	13.7
Miscellaneous personal goods	-4.1	0.2	13.9
Personal care products	-2.3	0.7	14.6
Miscellaneous personal services	-2.3	1.2	15.8
Women's and girls' apparel	-2.2	1.5	17.3
Household furnishings and operations	-2.0	4.5	21.8
Public transportation	-1.3	1.1	22.9
Nonalcoholic beverages and beverage materials	-1.0	0.9	23.8
Recreation	-1.0	5.4	29.2
Communication	-0.6	2.9	32.2
New vehicles	0.4	4.9	37.0
Alcoholic beverages	1.4	1.1	38.1
Cereals and bakery products	1.5	1.1	39.3
Owners' equivalent rent of primary residence	2.0	23.7	62.9
Rent of primary residence	3.4	5.9	68.9
Tobacco and smoking products	3.7	0.7	69.6
Other food at home	4.0	1.7	71.4
Motor vehicle insurance	4.3	2.2	73.5
Personal care services	4.9	0.7	74.2
Motor vehicle maintenance and repair	5.0	1.1	75.4
Food away from home	6.0	6.0	81.4
Motor vehicle fees	6.2	0.5	81.8
Motor vehicle parts and equipment	6.4	0.4	82.2
Education	6.5	3.1	85.3
Medical care commodities	7.1	1.4	86.7
Medical care services	7.9	4.9	91.6
Used cars and trucks	8.8	1.7	93.2
Lodging away from home	9.7	2.7	96.0
Processed fruits and vegetables	12.2	0.3	96.2
Water and sewer and trash collection services	12.2	0.9	97.1
Men's and boys' apparel	17.6	0.9	98.0
Footwear	19.8	0.7	98.7
Dairy and related products	38.0	0.9	99.6
Fuel oil and other fuels	49.5	0.4	99.9
Car and truck rental	110.6	0.1	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16 Percent Trimmed Mean
1 Month	1.4	2.9	2.0	1.8
3 Months	4.0	2.5	1.8	2.1
6 Months	4.9	2.2	2.4	2.6
12 Months	2.4	2.2	2.9	2.5
12 Months ended July 2006	4.1	2.7	3.1	2.9

Detail for Computation of the Median CPI