The Inflation Update

The trend in CPI inflation is stable at 3 percent. That's the news in this morning's report.

While headline CPI fell a substantial -5.7 percent at an annual rate (a.r.) for the month, core measures remained right around where they've been for a while now: 3 percent. The CPI excluding food and energy increased 2.9 percent (a.r.) in September, exactly its 12-month average rate. And the Median CPI computed by the Federal Reserve Bank of Cleveland was up 3.6 percent (a.r.) and is up 3.1 percent since last September.

Looking at the detail in the report confirms the conclusion that the inflation trend remains at 3 percent. To see it, first recall that the trend is approximately 0.7 times core service price inflation plus 0.3 times core goods price inflation. Over the past 6 months core service prices (services excluding energy services) increased at a 4.2 percent annual rate, while core goods prices (commodities excluding food and energy commodities) rose by 0.4 percent (a.r.): 0.7 x 4.2 + 0.3 x 0.4 = 3.1. This is nearly exactly equal to the 6-month change in the 16 percent trimmed mean, my preferred index of the inflation trend, which came in at 3.0 percent.

This morning's numbers do contain a straw to the inflation doves to grasp, albeit a very modestly: Both Owner Equivalent Rent and Food Away From Home are rising at somewhat slower rates. OER is up 3.6 percent for the month, below its 6-month average of 4.7 percent; and food away from home rose a very modest 1.8 percent, much less than its recent trend of 3 percent. But if inflation is falling, it is doing it very very slowly.

All of this validates concerns recently voiced by a variety of FOMC members, although I would phrase it slightly differently. Rather than describing upside inflation risks, I would be talking about risks that inflation won't fall. These worries are compounded by the recent estimates that the potential growth rate of the economy may have fallen below 3 percent to 2.75 percent. This has two important implications for monetary policy. The most immediate is that there is no slack in the economy today, so there is no output gap to bring inflation down. And second, the lower potential growth rate mean a lower long-run equilibrium (or neutral) real interest rate. These have opposite implications for the level of the interest rate -- no output gap means interest rates need to be higher, while a lower neutral real rate means they should be lower.

For some time I have been writing that the federal funds rate has to go to 6 percent. But with potential growth lower, I have moderated my views slightly. I now think that if the Fed is serious about bringing CPI inflation back to 2 percent, they will have to raise the funds rate to only 5.75 percent. That's two more increases, one in December and one early next year.

Consumer Price Inflation, Various Measures
(Through September 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
September 2006
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Motor fuel	-82.3	5.2	5.2
Fuel oil and other fuels	-45.0	0.4	5.5
Car and truck rental	-24.4	0.1	5.6
Infants' and toddlers' apparel	-20.2	0.2	5.8
Used cars and trucks	-11.2	1.8	7.6
Public transportation	-8.0	1.1	8.7
Processed fruits and vegetables	-7.5	0.3	9.0
Other food at home	-6.2	1.8	10.7
Jewelry and watches	-2.7	0.3	11.1
New vehicles	-1.7	5.0	16.1
Communication	-1.4	3.0	19.1
Tobacco and smoking products	-0.7	0.7	19.8
Dairy and related products	0.0	0.8	20.7
Footwear	0.0	0.7	21.4
Motor vehicle fees	0.0	0.5	21.9
Recreation	0.0	5.6	27.5
Household furnishings and operations	0.9	4.7	32.2
Alcoholic beverages	1.2	1.1	33.3
Cereals and bakery products	1.7	1.1	34.4
Food away from home	1.8	6.0	40.3
Tenants' and household insurance	2.1	0.4	40.7
Medical care commodities	2.1	1.5	42.2
Motor vehicle maintenance and repair	2.2	1.1	43.3
Nonalcoholic beverages and beverage materials	2.5	0.9	44.2
Education	3.0	3.0	47.2
Personal care services	3.5	0.7	47.9
Owners' equivalent rent of primary residence	3.6	23.7	71.6
Motor vehicle insurance	4.4	2.3	73.9
Medical care services	4.9	4.8	78.7
Rent of primary residence	4.9	5.9	84.5
Motor vehicle parts and equipment	5.2	0.4	84.9
Water and sewer and trash collection services	5.4	0.9	85.8
Miscellaneous personal goods	5.8	0.2	86.0
Meats, poultry, fish, and eggs	5.9	2.1	88.1
Miscellaneous personal services	9.1	1.2	89.3
Lodging away from home	9.2	2.6	91.9
Men's and boys' apparel	12.2	0.9	92.8
Personal care products	12.3	0.7	93.5
Women's and girls' apparel	12.6	1.6	95.1
Gas (piped) and electricity	15.7	3.9	99.0
Fresh fruits and vegetables	54.8	1.0	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16% Trimmed Mean
1 Month	-5.7	2.9	3.6	2.4
3 Months	0.8	2.7	3.8	2.9
6 Months	2.9	3.2	3.9	3.0
12 Months	2.1	2.9	3.5	2.8
12 Months ended September 2005	4.7	2.0	2.4	2.5

Detail for Computation of the Median CPI