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The Inflation Outlook

Contributed by Raymond James

By Scott J Brown

The Consumer Price Index rose 3.0% in 2011 (December-to-December), twice the rate of 2010. A big part of that increase was food and energy prices, which picked up in the first half of the year. Ex-food & energy, the CPI rose 2.2%, not especially high. The shorter-term trend in the CPI is benign. The overall CPI fell at a 0.4% annual rate in the final three months of the year, while the core rose at a 1.8% pace.

Economists tend to focus on core inflation because we’re interested in the underlying trend – not because food and energy prices don’t matter. However, there are a variety of core inflation measures, including the median CPI, trimmed mean estimates, and my personal favorite, the stick price index (which measures inflation in prices that tend not to change very often). All of these measures rose in 2011, but from very low levels in 2010. The Fed’s chief inflation gauge is the core PCE Price Index, which, among these measures, fell the least in 2010 and rose the least in 2011. Recall that the PCE Price Index is similar to the CPI except that the weights shift as consumption patterns change over time (in the CPI, the weights are adjusted every five years). The PCE Price Index ex-food & energy rose 1.7% in the 12 months ending in November, which is smack in the middle of the Fed’s implicit comfort range of 1.5% to 2.0%.

When the Fed embarked on its second round of asset purchases in 2010, officials were worried about the threat of deflation. The 2011 inflation results suggest that the Fed was successful in warding off deflation, but inflation did not surge as some had feared. In 2010, Chairman Bernanke argued that real interest rates are what matter. For a given nominal interest rate, lower inflation raises the real interest rate – and higher real interest rates are less stimulative for the economy. One line of reasoning, not expressed by the Fed, but embraced by a number of private-sector economists, is that the Fed should shoot for a higher inflation target in the current environment, to push real interest rates even lower and further stimulate the economy. However, a short-term push for higher inflation could un-anchor inflation expectations. Nominal interest rates could rise, keeping real rates steady. More importantly, the Fed would risk losing its inflation-fighting credibility.

So where is inflation headed in 2012? The Fed views inflation as being driven by inflation expectations, which act as a form of inertia, and the amount of slack in the economy. Inflation expectations have remained relatively low. The spread between the 10-year TIPS yield and the regular 10-year Treasury yield has been trending at around 2.0% (this spread isn’t really the market’s expectation of inflation, but a rough approximation).

The economy is still operating with a large amount of slack. Inflation pressures could heat up if that slack were to disappear, but this should be a very gradual process. The labor market is the widest channel for inflation. In the oil price shocks of the 1970s and early 1980s, inflation quickly became embedded in the labor market. That hasn’t been the case more recently. Union membership was a lot higher in the 1970s and many unions had wage contracts tied to the Consumer Price Index. We’ve had a number of increases in oil prices over the last 10 years, but there’s been no sign that pressures have fed through to wages.

Higher oil prices, in recent years, tend to be associated with slower growth – a short-term burst of inflation, but not a higher inflation trend. Oil prices remain a significant wildcard for the growth outlook in 2012, but also for the inflation outlook.

Despite the moderate inflation results for 2011, some still believe the Fed’s accommodative policy will lead to a substantial increase in inflation sooner or later. However, we’re still a long way from a full economic recovery, and there will be plenty of time to unwind the Fed’s accommodation when appropriate.