Inflation’s Comeback?

The January CPI report was released this morning by the BLS. It was eagerly awaited by the financial markets, because last week’s PPI report showed a surprisingly strong rise in producer price inflation in January. As a result, many observers wondered if the CPI report would confirm a significant rise in inflation, or if instead it would suggest that the inflationary January PPI number should be taken with a grain of salt. In the event, today’s CPI report will probably suggest the latter:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in January, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today.

…On a seasonally adjusted basis, the CPI-U, which was unchanged in December, increased 0.1 percent in January… Energy costs declined 1.1 percent, following a 1.3 percent drop in December. Within energy, the index for petroleum-based energy declined 2.2 percent while the index for energy services rose 0.1 percent. The index for all items less food and energy increased 0.2 percent in January, the same as in each of the preceding three months.

As usual, I will add the caveat here that any one month’s numbers are of limited importance due to the normal month-to-month volatility in most economic statistics; the bond market’s rather strong reaction to the January PPI report last week seemed to be considerably exaggerated. A much better gauge of trends in inflation is the 12-month percent change in prices, which I’ve depicted in the following chart.

Producer price inflation has indeed been on a strong upward trend over the past year (even excluding higher energy prices), and non-energy consumer price inflation has also drifted upward, albeit less dramatically. So even though today’s CPI report was quite tame by itself, it’s clear that over the past year all broad inflation measures for the US seem to have moved solidly into the 2-3% range (the GDP deflator rose by about 2.4% over the four quarters of 2004).

This raises some interesting questions, the most important of which is probably how much inflation the Fed is willing to tolerate. Most inflation-targeting schemes (such as that of the European Central Bank) try to keep inflation below a maximum of 2% or 2.5%. Yet the US economy clearly seems to be heading above those limits. Furthermore, if the dollar falls further this year (particularly against Asian currencies), as many expect, then inflation is likely to rise even further from current levels.

From an inflation-targeting point of view, therefore, it appears to be time for the Fed to enact a rather tight monetary policy with some aggressive interest rate increases, in order to stamp out any gathering inflationary momentum. On the other hand, if the Fed doesn’t tighten more aggressively over the next few months (and I actually would be quite surprised if they deviate from their recent pattern of steady quarter-point rate hikes), then that suggests to me that Greenspan is significantly more tolerant of inflation than most of his central bank counterparts around the world. Personally I have no problem with that (unlike the ECB, I think inflation of 3-4% is probably perfectly fine), but I wonder if the financial markets would agree…