Weighing Recent Inflation Data

 | Nov 18, 2011 | 3:19 PM EST  | Comments
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With all the attention placed on Europe recently, we may have been remiss in looking at other important economic data. Take inflation, for example. Earlier this week, we received the Consumer Price Index (CPI) and the Producer Price Index (PPI) from the Bureau of Labor Statistics.

Quietly, it seems, inflation has become a non-issue. In October, the CPI printed a -0.1% read on the headline measure, as gas prices had fallen; the core number, which excludes food and fuel, advanced only 0.1%. Over the past 12 months, the all-items index has risen 3.5%, a decline from last month's 3.9% increase, but core inflation edged up from 2.0% to 2.1%.

The Federal Reserve would like to keep core inflation at 2% or slightly less, though I note that the Fed's preferred measure of inflation is not the CPI, but the measure of prices tied to personal consumption expenditures published by the Bureau of Economic Analysis, and this read for October has not been released yet. As of September, though, this inflation measure was in its target range, measured on a year-over-year basis.

What can we expect in regard to inflation going forward? The answer depends on what we expect. Jeffrey C. Fuhrer of the Boston Fed recently published "Inflation Expectations and the Evolution of U.S. Inflation," and "The Role of Expectations in U.S. Inflation Dynamics," two papers on the subject of how inflation expectations are determinants on inflation. It turns out that people's expectations of price and wage increases often are big determinants in how those variables actually turn out. Of course, some room exists for an output gap -- the slack in the economy, such as measured by the unemployment rate -- but this output gap is often intuitively or quantitatively expressed in those inflation expectations.

How does this work? Consider that wages are roughly two-thirds or so of the typical company's cost structure. Unemployment is now high, so people are not expecting big wage increases, regardless of whether gas or food prices surge or recede. The Consumer Confidence data, released from The Conference Board, show that the proportion of consumers who anticipate an increase in their incomes declined to 10.3% from 13.5% for the next six months. Another consumer survey, the Thompson/Reuters University of Michigan's Consumer Sentiment report, reveals that consumers' one-year inflation expectation held steady at 3.2%, while the survey's five-to-10-year inflation outlook eased to 2.6% from 2.7%, its lowest since March 2009.

The Survey of Professional Forecasters, compiled by the Philadelphia Fed, is a measure that the Fed tends to focus on and is perhaps the best metric. The survey shows that headline CPI inflation in 2012 will average 1.9%, down from 2.0% previously, while core CPI inflation in 2012 will average 1.8%, unchanged from the previous survey, and it will rise to 2.0% in 2013. This is in line with the Treasury Inflation-Protected Securities (TIPS) market, which shows consumer inflation expectations at 2.0%, using the 10-year Treasury and TIPS breakeven. Importantly, these inflation expectations of the public are almost exactly in line with the Fed's own inflation projections.

As such, the Fed may feel comfortable that inflation expectations are well moored, especially since core CPI is near its target range. This gives it the flexibility to maintain its accommodative stance, which it has pledged to do until mid-2013, but it also means that it may be reluctant to engage in more monetary stimulus to spur economic activity -- unless it is willing to accept possibly higher inflation as a potential result of further actions.

Of course, recent economic indicators have come in better than expected (as I wrote about in "Green Shoots in the U.S. Economy,") and some signs of improving labor market conditions exist (see "Early Glimmers of a Jobs Rebound"). That means that, with a Fed divided about whether to take further action or not, it may want to wait until it sees further evidence that core inflation has indeed settled at or below its target range or further signs of economic weakness. Remember that previous Fed monetary stimulus measures were enacted when inflation expectations were well below the Fed's target; but, that is no longer the case today. (In fact, the Fed tried to combat the potential of deflation in the earliest days of quantitative easing (QE), but that threat seems to have long since subsided.)

Of course, the obvious risk to growth stems from Europe, and we will have to see how events play out there. Will a global recession result, easing price pressures? Or, will the European Central Bank (ECB) launch a bond buying program if Germany – which is adamantly opposed to the idea, given its painful experience of inflation caused by central bank actions during the Weimar Republic – decides that such action is both necessary and appropriate, and thus provide monetary stimulus that might spark global inflation? These are questions that the Fed is probably asking now. But, at least, they might feel comfortable knowing that inflation expectations and core consumer inflation are near their targets.

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