The Inflation Update: November 2005
Stephen G. Cecchetti
15 December 2005

Waltham, Massachusetts

This morning's inflation release is good news for some people, and bad for others. For firm's whose cost-of-living adjustments are based on the December to December headline measures, the -6.4% annual rate (a.r.) drop in the all-items CPI means these escalators will absorb less revenue than had been feared. It now looks like inflation for 2005 will be about 3.5%.  But the 3.0% (a.r.) rise in the traditional measure of core, the CPI excluding food and energy, is clearly bad news for monetary policymakers.  And the 2.6% (a.r.) rise in the Median CPI computed by Federal Reserve Bank of Cleveland confirms that the inflation trend is rising.

From the detail in the report, we can see that services are the source of the increased inflation pressure..  Core services prices (services excluding energy services) increased 4.6% (a.r.) for the month, well above their 12-month trend of 2.9%.  And the month's increases are across the board:  owner equivalent rent (OER) rose 2.6% (a.r.), medical care services were up 7.3% (a.r.), lodging away from home increased 16.9% (a.r.), motor vehicle insurance is up 4.5%, and it goes on. Goods prices are a bright spot, with commodities excluding food and energy commodities falling modestly in November and roughly unchanged over the past 12 months.

Going forward, the biggest inflation risk continues to be in housing.  While OER has risen a modest 18% over the past 6 years (less than 3% at an average annual rate) the OFHEO matched-resale housing price index is up more than 60% over the same period (that's nearly 9% at an average annual rate).  In fact, replacing OER with the OFHEO index raises average CPI inflation since 2000 from 2.7% to about 4%!  Over the long run, we can expect rents to reflect the market value of homes. There are two ways that this can happen.  Either rents will rise, or home prices will fall.  That is, we will get inflation, a housing crash, or both.

Returning to monetary policy, Tuesday's statement signals the FOMC's belief that policy is in the neutral range.  While there is both discomfort with the claim of precision and disagreement over the level of the neutral interest rate itself, most estimates suggest that at 4.25% the federal funds rate is now one-quarter of a percentage point away from neutral. And that final move will likely come at the end of next month. Any  increase beyond 4.5 will depend on the inflation data.  And as I have just suggested, here the news is not good.  My view is that containing inflation will require raising the funds rate to 5%.  As some analysts have noted very recently, is going to be risky as it will mean slowing the economy below its 3.5% trend rate of growth in 2007. Balancing the risks, tightening just enough to keep inflation in check while not choking off growth is going to be difficult.  I'm sure that that Ben Bernanke and his colleagues are up to the task.  

Consumer Price Inflation, Various Measures
(Through November 2005, 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

 (Note:  If you have trouble viewing the tables, you may prefer looking at them in html at
 people.brandeis.edu/~cecchett/pdf/inf12_05.htm)