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The Inflation Update: July 2005 Waltham, Massachusetts Well, I had hoped that a few weeks of vacation clear up my confusion about the bond market. But, the mountain of New Zealand didn't do the trick. When I got back, the Treasury yield curve was continuing to flatten as the FOMC raised their federal funds rate target and the 10-year bond yield stayed stubbornly near 4.25%. This morning’s CPI data provides a moment of relief. I definitely understand this, and my conclusion is that inflation remains close to, but below, 2.5%. According to the Bureau of Labor Statistics the all-items CPI rose at an annual rate of 6.4% in July. But as anyone who drives, reads, or watches television would conclude, oil prices had quite a bit to do with this. In fact, energy prices rose at a 56.8% annual rate for the month, so the contrast between the headline and the core inflation measures even is bigger than normal. But which core measure you look at turns out to matter. While the traditional CPI excluding food and energy was up a modest 1.8% (a.r.), the Median CPI computed by the Federal Reserve Bank of Cleveland increased a more substantial 2.6% (a.r.). There are several ways to resolve the conflict between these two imperfect gauges of core inflation. One is to look inflation over the past six months. Here things look a bit more stable, with the CPI ex. food and energy and the Median CPI showing 2.1% and 2.6% increases, respectively. Alternatively, we can turn to the detail in the report. Here we see that owner equivalent rent rose 2.6% (a.r.) during July, in line with its recent trend. For the time being, this has been counterbalanced by the –3.4% (a.r.) fall in core goods prices (commodities excluding food and energy commodities). But the decline in goods prices is at least in part a consequence of the –7.7% (a.r.) fall in the price of new cars. Importantly, though, even with the "employee discount pricing," new car prices are still higher today than they were a year ago. It surely looks as if the fall in goods prices is unsustainable, and that rising service prices (+4.1% a.r. in July) will keep overall inflation near 2.5%. So, what about those interest rates? Over the past week I think I've made some progress. First, the FOMC members are almost surely weighing the need to move from an accommodative to restrictive policy. That is, they are asking whether it will be necessary to raise the federal funds rate above 4.5%. Meanwhile, bond market traders have placed their bets. They think that the answer that the FOMC in fact stop short of 4.5%, and they have a case. The current boom has been based on household spending. With oil prices double their December 2003 level, and the housing market on the verge of stagnation if not collapse, it is logical to conclude that consumption growth will slow.* Put another way, US households are not saving. Unless they start dissaving, consumption cannot grow any faster than income. A quick calculation suggests that for GDP growth to stay at 3.5%, this means that business fixed investment will have to at a 15% annual rate, which will require lower not higher interest rates. Policymakers don't seem to buy into this story, so they are likely to keep raising interest rates in the near term. But it will take us a few months at least to figure out who is right.
*For a discussion of housing booms, consumption and policy see my comment in the Financial Times on 8 August 2005. Consumer
Price Inflation, Various Measures
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