The Inflation Update: November 2007
Stephen G. Cecchetti
14 December 2007

Lexington , Massachusetts

Flying over the Atlantic yesterday, I was oblivious to the storm that was covering Eastern Massachusetts with a foot of snow.  When I called home at 10pm to say that I had arrived at the airport, albeit 2 hours late, my wife expressed surprise that I had made it.  The afternoon storm brought the whole Boston area to its knees. Even so I love snow like this, especially when the sun comes out early the next morning. Not only is it beautiful, but until the cars get moving again, it's quiet.  It makes me wonder how it must have been two hundred years ago, before people started building noisy machines: idyllic for the moment before you get back figuring out how to keep from starving or freezing to death. 

Writing about inflation in the midst of a financial crisis is a bit like thinking about the beauty and calm of the snow when your main concern staying alive for another day.  Unfortunately, today policymakers are doing their best to get the financial system out of intensive care.  Inflation is not their immediate priority; nor should it be.  But this is an inflation report, so here goes:

This morning's consumer price index numbers are scary. Policymakers will definitely have some work to do when they are done administering emergency care. The headline, all-items, Consumer Price Index (CPI) rose a whopping 10.0 percent at an annual rate (a.r.) from October to November, and is up 4.3 percent since November 2006.  Some people might ascribe this to transient energy price increases – energy prices rose 95.6 percent (a.r.) last month and are up 21.4 percent over the last 12 months.  But core measures of inflation suggest that it would be a mistake to discount these numbers.  The traditional CPI excluding and energy rose 3.3 percent (a.r) for the month, well above recent readings.  And both the median and trimmed-mean CPIs computed by the Federal Reserve Bank of Cleveland spiked as well, increasing 3.7 percent (a.r.) last month.

The detail in the report is very troubling.  First, nearly 70 percent of the index showed increases of more than 2 percent (the level that I take to be the mid-point of the Fed's implicit medium-term inflation object as measured by the CPI).  Looking further, we see that core goods prices (commodities excluding food and energy commodities) rose 2.1 percent (a.r.) in November. This is well above the recent trend, which is roughly zero.  I wonder if we are finally starting to see some exchange rate pass-through.  And then there is housing.  Owner equivalent rent (OER) registered an outsized 4.1 percent (a.r.) increase for the month, far higher than the recent reading that have been in closer to 3 percent (or less). Recall that OER is computed from rents, and these tend to rise in times when it less appealing to purchase a home – there is a shift from owning to renting when the housing market tanks. Overall, this leads me to conclude that the consumer price inflation trend is now edging back up above 2.5 percent.

That said, the inflation picture could change very quickly. If the financial market turmoil persists, and the real economy starts to suffer, I would expect inflation to fall, too.  But if financial problems are resolved fairly quickly, as everyone hopes, then inflation should back to the top of the policymakers’ agenda almost immediately.  In the meantime, though, standard economic data doesn't really mean very much.  It simply doesn't help us understand either the likely future path of the economy or what policymakers are apt to do.

Now that we've gotten the inflation part of the report out of the way, let's turn to financial markets.  Well, they are still a mess. Inter-bank funding for even one month continues to be very expensive. Yesterday, one-month LIBOR (the interbank lending rate for a one-month uncollateralized loan) was 5.0275.  That's 77 basis points (0.77 percentage points) over the federal funds rate target, which is roughly 10 times the spread prior to the start of the crisis.  And, importantly, since the announcement of the coordinated effort on Wednesday there was virtually no change in this spread (or the spread of 3-month LIBOR over fed funds). 

For those of you who don't live and breath this stuff, let me explain briefly what happened on Wednesday.  At 9am Eastern US Time on 12 December, the Federal Reserve, European Central Bank, Bank of England, Swiss National Bank and Bank of Canada announced that they would all work to inject dollar liquidity into the financial system.  The Fed would do this through a newly designed auction facility that would all all banks to participate (something they can't do in normal daily operations) and the foreign central banks were getting dollars from the Fed to auction off to the banks in their countries.  The idea is that the central banks have tools for putting liquidity into the system, but no for distributing it.  The Fed can't get dollars to either small U.S. banks or to foreign banks.  By setting up an auction that all American banks can participate in, they address the first issue; and by providing dollars to foreign central banks, they tackle the second. 

If it works, one- and three-month inter-bank lending rates should fall to something closer to their historical levels, relative to the overnight lending rate (that's the federal funds rate). So far, market participants are distinctly underwhelmed. But then, things don't start in earnest until Monday.  I have my fingers crossed.

Consumer Price Inflation, Various Measures
(Through November 2007, all data s.a. at an annual rate)

 *Revised versions of the median and trimmed mean that utilized regionally disaggregated owner equivalent rent.

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