This past week has been heavy on inflation data, with the Bureau of Labor Statistics releasing its monthly inflation gauges, import prices, producer prices (PPI) and consumer prices (CPI). As had been the case in the past number of months, the headline PPI and CPI numbers have shown a higher degree of inflation than has core inflation, which excludes food and fuel.
Commodity prices are notoriously volatile, and they often revert back to longer-term trends. However, there is ample concern by economists, policymakers and investors about whether higher input prices from commodities will eventually make their way into prices for core goods, resulting in more persistent inflation trends. Or, on the other hand, will the opposite happen, with the headline inflation readings eventually converge toward the (lower) core measure? Research from the San Francisco Fed suggests that the higher headline inflation is more likely to be transitory and converge lower toward core inflation, rather than the other way around. But there are some very important caveats.
But before I discuss those, here's a recap of this week's CPI and PPI. The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5% in July -– the biggest gain since March -- and over the last 12 months, the all-items index increased 3.6%. Core, however, showed some increasing year-over-year inflationary trends but they moderated month over month. However, this is still at a much lower reading than the headline. The change in the index for all items (excluding food and energy) continued its upward trend, rising to 1.8%, year over year, in July. It had been as low as 0.6% in October 2010, though the monthly increase in core was just 0.2%, down from 0.3% in the prior two months.
What happens further back on the supply chain also matters. Some businesses may be unable or unwilling to pass along all of their cost increases along to their customers, especially if they believe that inflation is likely to mean-revert and head lower at some point. And indeed, we do see that the PPI measure for finished goods rose more substantially than did the CPI measure, measured over the past 12 months, with an increase of 7.2% vs. the 3.6% rise in headline CPI. And core goods prices rose by 0.4% in July – the largest monthly rise since January. Businesses are not passing along all of these cost increases to the end customer, which may signal that they don't want their selling prices to reflect their volatile input prices.
And that is the message from the research from the San Francisco Fed, which recently published a paper entitled, Does Headline Inflation Converge to the Core? Its research on inflation data since the early 1990s shows that headline inflation does indeed tend to converge to the core rate of inflation, not the other way around -- at least while inflation expectations are well anchored and the public has confidence in the Fed's inflation-fighting abilities.
This is what separates the past 20 years or so from the experience of the 1970s and 1980s, when rampant energy and other commodity costs fed their way into core inflation, making it a more protracted battle to fight. By the late 1980s, the Fed had successfully brought down inflation, so expectations moved lower -- and in the early 1990s, so did inflation itself. Also, labor contracts that tied wage increases to inflation caused more inflation in the 1970s and 1980s; those conditions don't exist now, and high unemployment could keep wage pressures moderate, as that is often a typical company's biggest cost component.
In the current environment, inflation expectations are key; so is considering what the public's expectations are. The higher inflation rate for finished producer goods vs. consumer goods (all items) indicates that companies are probably expecting inflation to come down. That might be why they are not adjusting their selling prices accordingly. This is the Fed's general view. For the most part, inflation expectations are still well-anchored, though the University of Michigan Consumer Sentiment data does show inflation expectations are ticking up a bit.
The risk to the Fed is that its reputation for fighting inflation could become impaired should the public believe that its policies have actually caused higher prices for gas, food, clothing, etc. The Fed has been more or less adamant in its view that higher food, fuel and other commodity prices are not the result of its monetary stimulus policies – including pumping all that cash into the system through the QE programs, along with the knock-on effects those policy moves have had on weakening the dollar. (A weaker dollar tends to make imported goods more expensive, and since many commodities are priced in dollars, a weaker dollar can mean higher commodity costs for U.S. purchasers.)
Instead, the Fed views higher commodity prices as a result of increased demand from growing emerging markets while supplies are, generally speaking, rather finite in nature. These commodity price increases will eventually flatten out, or perhaps even reverse. For example, the recent fall in crude oil prices has resulted in more moderate headline inflation in the future.
I do tend to agree with the Fed's views on the primary cause of inflation in certain commodities, but that doesn't mean the public is buying that explanation. Instead, they may view the Fed's actions suspiciously, and should QE3 come to pass, the public may view this as even more inflationary than the Fed's actions to date. It could cause inflation expectations to become unmoored, and that itself can cause inflation to accelerate.
For this reason, I do think the Fed will be very cautious in its actions and have a very high threshold for engaging in QE3. Its reputation is at stake, and that is crucial to keeping inflation from becoming a more persistent problem than a relatively transitory phenomenon.