Friday, February 19, 2010

CPI Inflation, Nearly Perfect

The CPI report for January, showing a gain of 0.2% in the overall index and a 0.1% decline in the core measure, helps bring to focus some key elements of the broader inflation picture in the current environment.

In terms of the January report itself, the discrepancy between the overall CPI and core was almost entirely due to a sharp rise in energy prices (+2.8%) and, particularly, gasoline (+4.4%). The unusual drop in the core last month (its first decline since 1982) was largely the result of an uncharacteristic pullback in the shelter component (-0.5%) which accounts for 33% of the overall CPI; in turn, the decline in the shelter component was driven by a sizable drop of 2.1% in hotel prices ("lodging away from home").

Moving beyond the specifics of the January report, the overall CPI is now up 2.6% from a year ago, while the core index has risen 1.6%- versus a 1.8% year-on-year gain to December 2009. (In reality, both measures would have been even lower on a year-on-year basis, if it were not for a 30% surge in tobacco prices that have added approximately 0.3 percentage during that period).

Source: Bureau of Labor Statistics

Despite pronounced -and exaggerated- anxiety in the wake of the financial crisis and deepening recession in the second half of 2008, that the economy might be facing the specter of deflation, the behavior of the CPI in recent months has safely put such fears to rest. Despite a severe weakening in labor market conditions and ensuing wage trends, as well as a sharp reversal of oil and other commodity prices in late 2008 and early 2009, core inflation has remained comfortably within a 1.5 to 2% range. While some further modest downward drift in the months ahead even as the economic recovery gains traction is still possible (inflation is appropriately considered as a lagging indicator), it is likely to bottom out in the 1 1/4% to 1 1/2% range later in the year.

This leaves the inflation picture at an almost ideal spot. The severity of the recession has predictably enough pushed the core CPI lower by one percentage point (from about 2.5-2.6% in the summer of 2008 to 1.6% today) but any further disnflationary forces are steadily diminishing in the context of an economic recovery taking hold. The substantial, but reasonable, moderation of inflation provides the Fed with some breathing room in its upcoming campaign to normalize the structure of short term rates over the next 12 to 18 months. At some point, over that time frame, inflation will probably show an upturn and, given its inherent inertia, this may not be fully successfully contained by the Fed at first. But with the cushion that the recent retreat of core inflation provides, a moderate bounce back of inflation next year is not likely to trigger any widespread anxiety over the risk of a disturbing comeback.

Anthony Karydakis