The Inflation Update

Should today’s business headline read something like this: "Inflation tame, Fed strategy working"?

Well, this morning's release reports that that the all-items CPI fell -5.8 percent at an annual rate (a.r.) for the month of October. With gasoline prices down -11 percent for the month (that's -76 percent at an annual rate), this is only a small shock. More surprising is that conventional core inflation is only 1.2 percent (a.r.) for the month. But this may be a bit misleading, as Median CPI computed by the Federal Reserve Bank of Cleveland rose 3.7 percent (a.r.).

Any conclusion that inflation is falling is not supported by the detail in the release. At least, not yet. Prices of food away from home rose 3.7 percent (a.r.) for the month, well above their 12-month average of 3.0 percent. And the same is true for owner equivalent rent, which showed an increase of 4.6 percent (a.r.), one half a percentage point above its 12-month average of 4.1 percent. What this means is that service prices continue to rise at a rate between 3.5 and 4.0 percent, suggesting that the overall inflation trend is between 2.75 and 3.0 percent. (Remember, services make up seventy percent of core inflation.)

Inflation optimists will point to falling goods prices and conclude that the inflation trend is on its way down. While it is certainly true that core goods prices fell substantially in October (the number is -3.4 percent at an annual rate), they are roughly flat over the past year. Now, this is a modest improvement, but I wonder if it will be enough.

So, is the 5.25 percent target on the Fed Funds rate high enough to bring inflation down to 2 percent any time soon? I seriously doubt it. While forecasts for economic growth in 2007 are in the process of being downgraded to about 2 percent, I expect that sustainable growth (that is, growth in potential output) will be downgraded at the same time--to about 2.5 percent. This means that even if economic growth moderates, it may not hold inflation down by much. I continue to believe that the FOMC needs a few more interest rate hikes to make much progress in reducing the inflation trend.

Let me conclude with three short comments, one on wages, one about gasoline prices, and one about Europe . Starting with wages, there is clear concern that increases in labor compensation are going to find their way into prices. And this morning's data are clearly consistent with that. My guess is that there is a high correlation between labor's share and inflation in the components of the index. It will be interesting to see what happens over the next few months.

On gas prices, the gyrations have been astoundingly large. From July to September 2005, gasoline prices rose roughly 27%. By the end of the year, they were back to where they had started. Then, over the first half of this year, prices were up 30% (cumulatively), and today we learn that they are now back to the level of July 2005, which is the same as they were last December. That's two cycles -- up and then down by more than one 25 percent -- in a period of 18 months. That's why we need to look at core inflation to measure medium term trends, and that's why there is unlikely to be much pass through.

On Europe , evidence is mounting that US and the EU are trading places in an important way. Growth here is falling, while it rising on the eastern side of the Atlantic . And, while inflation is high here, it is low there. Might Europe finally be experiencing the productivity growth increases that American's saw in the late 1990s? It would surely be nice, especially for our European friends. But for the US, it could mean the end to goods price declines. The next year will tell.

Consumer Price Inflation, Various Measures
(Through October 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
October 2006
Component	1-month annualized percent change	Relative importance (Normalized)	Cumulative relative importance
Motor fuel	-75.6	4.5	4.5
Fuel oil and other fuels	-45.8	0.3	4.9
Gas (piped) and electricity	-26.0	4.0	8.9
Women's and girls' apparel	-14.0	1.6	10.5
Used cars and trucks	-13.5	1.8	12.3
Public transportation	-10.9	1.1	13.4
Men's and boys' apparel	-10.9	0.9	14.3
Lodging away from home	-6.0	2.7	16.9
Processed fruits and vegetables	-4.8	0.3	17.2
Jewelry and watches	-4.4	0.3	17.5
Communication	-2.8	3.0	20.5
Tenants' and household insurance	-2.0	0.4	20.9
New vehicles	-1.7	5.1	26.0
Motor vehicle fees	-1.7	0.5	26.5
Fresh fruits and vegetables	0.0	1.0	27.5
Household furnishings and operations	0.0	4.7	32.2
Medical care commodities	0.0	1.5	33.7
Recreation	0.0	5.6	39.3
Tobacco and smoking products	0.7	0.7	40.0
Personal care products	1.5	0.7	40.7
Meats, poultry, fish, and eggs	1.9	2.1	42.8
Motor vehicle parts and equipment	2.0	0.4	43.2
Other food at home	2.1	1.8	45.0
Alcoholic beverages	3.0	1.1	46.1
Food away from home	3.7	6.0	52.1
Cereals and bakery products	4.0	1.1	53.2
Motor vehicle insurance	4.0	2.3	55.5
Nonalcoholic beverages and beverage materials	4.1	0.9	56.4
Medical care services	4.5	4.8	61.2
Owners' equivalent rent of primary residence	4.6	23.9	85.1
Rent of primary residence	4.9	5.9	91.0
Water and sewer and trash collection services	5.3	0.9	91.9
Personal care services	5.8	0.7	92.6
Footwear	6.0	0.7	93.3
Miscellaneous personal services	6.2	1.2	94.5
Motor vehicle maintenance and repair	6.8	1.1	95.6
Education	7.6	3.1	98.7
Dairy and related products	9.0	0.8	99.5
Miscellaneous personal goods	10.2	0.2	99.7
Infants' and toddlers' apparel	17.9	0.2	99.9
Car and truck rental	32.2	0.1	100.0

Previous	All Items CPI	CPI ex Food & Energy	Median CPI	16% Trimmed Mean
1 Month	-5.8	1.2	3.7	0.9
3 Months	-2.9	2.3	3.5	2.1
6 Months	0.7	2.8	4.0	2.7
12 Months	1.3	2.7	3.6	2.7
12 Months ended October 2005	4.3	2.1	2.4	2.5

Detail for Computation of the Median CPI