Inflation Resurgent?

Following up on yesterday’s PPI report, the BLS released its latest figures on consumer price inflation this morning:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.6 percent in February, 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 advanced 0.4 percent in February, following a 0.1 percent increase in January. The energy index,which registered substantial declines in the preceding two months, increased 2.0 percent in February, accounting for virtually all the acceleration in the overall CPI-U… The index for all items less food and energy, which increased 0.2 percent in each of the preceding four months, advanced 0.3 percent in February.

Both the CPI and PPI inflation measures are showing roughly the same thing: a continuation of the gradual upward creep in inflation rates, as the following chart illustrates.

I think that this exactly what the FOMC was referring to in their statement yesterday, which suggested the the Fed is becoming more vigilant about mounting inflation pressures. Note, however, that these growing inflationary pressures are not solely due to higher oil prices. In fact, it’s not a foregone conclusion that higher energy prices will translate into higher non-energy prices at all. One might reasonably believe that when the price for any one particular commodity changes, that simply causes a change in relative prices, not the overall price level. In this case, as people spend more of their income on energy and less on other things, one might expect the price of non-energy goods to have to fall as demand falls, leaving the overall price level unchanged but leaving relative prices quite different.

Naturally, if prices are downward sticky (which I think is probably often the case) then this story doesn’t work so well, however. So I do think that higher oil prices will probably have some additional impact on the aggregate inflation rate. Furthermore, I think that there are large potential price effects still in the pipeline due to both past and future falls in the dollar – not to mention the continued price effects of the vast quantities of global liquidity that the world’s central banks have created over the past few years. For all of these reasons, I am personally rather inclined to think that inflation still has further to rise from here.

One last note: as I mentioned in my post yesterday, the bond market reacted quite negatively to the Fed’s statement. Yet (as some noted in the comments to yesterday’s post) this does not necessarily reflect new inflation expectations in the market; inflation-adjusted interest rates (rates on TIPS) rose by just as much as nominal interest rates yesterday, suggesting that there was no major change in inflation expectations. In fact, today’s average market expectation for inflation over the coming 5 years (measured as the difference between the yield on the 5 year TIPS, which is currently about 1.45%, and the regular 5 year bond, which is yielding about 4.35%) remains at 2.9%, right where it has been for the past couple of weeks.

I find it interesting that current average inflation expectations are just about the same as the actual inflation that we’ve seen over the past 12 months. Thus the market seems to expect no further increase in inflation. Myself, I’m less sanguine. For the first time in the long time I’m starting to wonder if inflation-indexed bonds won’t provide a better deal than nominal bonds over the next 5 years…