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Inflation and the fed

Contributed by Raymond James

By Scott J. Brown

A year ago, in a sharply weakening economy, deflation seemed a credible threat. However, a rebound in energy prices has boosted the Consumer Price Index over the last 12 months. Improvement in the global economy has led to a firming in commodity prices. Despite the diminished threat of deflation, core inflation at the consumer level has trended lower, thanks in large part to weakness in rents (a consequence of residential housing troubles). Policymakers at the Federal Reserve have signaled that economic conditions are likely to warrant exceptionally low interest rates “for an extended period.” Those conditions include an elevated unemployment rate, a low trend in core inflation, and well-anchored inflation expectations. None of that seems likely to change anytime soon.

The Consumer Price Index ex-food & energy is the most common measure of core inflation. Food & energy do matter, of course – and the headline CPI is used to adjust things like Social Security payments – but we are most interested in the underlying trend in inflation. Food and energy prices, being volatile, tend to add a lot of noise. The Fed’s focus has traditionally been on the price deflator for personal consumption expenditures. While the Consumer Price Index is based on a fixed basket of goods and services, the PCE Price Index allows the weightings to change as patterns of consumption change. The core PCE Price Index rose 1.4% in the 12 months ending in January. There are other measures of core inflation. These include median measures (reflecting the middle of price changes) and trimmed-mean measures (which exclude some portion of the highest and lowest price increases each month). All of these measures have been trending at low levels.

With an elevated unemployment rate, a low trend in core inflation, and steady inflation expectations, there should be no pressing need for the Fed to raise the federal funds rate target. Some of the Fed’s district bank presidents have made hawkish comments, suggesting that rates may need to be hiked sooner rather than later. However, Bernanke is an expert on the Great Depression and realizes the danger of tightening credit too soon (moreover, with consumer and business credit declining, why should the Fed want to tighten credit?).

Energy prices are a wildcard in the economic outlook. However, recent history suggests that higher oil prices are more of an impediment to economic growth than a catalyst for a higher trend in underlying inflation.