I admit to being a curmudgeon when it comes to inflation. I believe inflation is a monetary phenomenon. While we can debate what constitutes the definition of money, by any measure the Federal Reserve created a lot of it in the past year.
Money growth has slowed dramatically this year. M2 growth has decelerated to a 2.4 percent annualized rate in the three months ended March from an 11.5 percent pace in the three months ended November. I'm not sure why M2 has slowed, but I'm watching it like a hawk for clues about the future.
I've also been watching like a hawk for the pass-through of earlier monetary stimulus into the price indexes. On that score, there was no sign of it in Tuesday's report on consumer prices for March. Despite a 3.8 percent increase in energy prices, the CPI rose a smaller-than-expected 0.3 percent. The core index, which excludes food and energy, rose a tame 0.1 percent, paring the year over year increase to a 20-month low of 2.4 percent.
Is this the long-awaited break in inflation economists have been predicting? On first glance, the CPI report had me baffled.
Going straight to shelter, the largest component accounting for 31.5 percent of the index, the parts didn't seem to add up to the whole. Shelter costs rose 0.1 percent last month, but 90 percent of the shelter index -- owners' equivalent rent and residential rent -- rose 0.3 percent or more. How does this compute?
"It's the lack of precision because of rounding," says Pat Jackman, senior economist at the Bureau of Labor Statistics, which produces the CPI. Jackman agreed with me that it "doesn't make much sense when you look at it." Carried out to several decimal places, the indexes for OER and RR rose 0.25 percent and 0.33 percent respectively, lower than the 0.3 percent and 0.4 percent increases calculated from the rounded indexes in the report.
"Because of the rounding, it appears that the indexes [OER and RR] are higher than they are when they feed into the shelter index," Jackman says.
Both OER and RR are still rising at a 4 percent three-month annualized rate. That's well above the overall inflation rate but down from cycle peaks. It may well be that the softness in the residential rental market in major metropolitan areas such as New York, Boston and San Francisco is starting to show up in the CPI.
(Both OER and RR are derived from a survey of rental units.) Not everyone is convinced.
"I'm having a hard time with the core CPI," says Joe Carson, an economist at Alliance Capital Management.
Carson added up the major components of the core CPI -- OER, RR, home insurance, apparel, new and used vehicles, medical care, education, recreation, communications, and personal care -- and found that 85 percent of the core CPI went up faster, albeit barely, in March than in February. "Yet the [monthly increase in the] core CPI went from 0.3 percent to 0.1 percent. It means that there's a lot of noise in the remaining 20 percent of the core index."
Some of that noise emanated from tobacco prices, which fell 3.5 percent in March following a 3.8 percent increase in February -- a 7 percent swing in 1 percent of the index.
"I don't see any change in the trend," Carson says, citing the Cleveland Fed's median CPI, which rose 0.3 percent in March. "Key drivers of the CPI are rents, education and medical care, and those components are still rising at a 3.5 to 4 percent annual rate."
What was a distinct break from the trend was the 0.1 percent increase in services prices, both with and without energy, in March. It was the smallest increase in core services since June 1999.
Prices of labor-intensive services tend to be "sticky," and there isn't a whole lot of slack in the labor market. If the March increase is the start of a deceleration in core services, it will be a change in the trend.
One would have thought the unexpectedly good inflation news would be perceived as giving the Fed some breathing room. Yet the implied yield on the fed funds futures and eurodollar futures rose on the day.
Clearly the strength in industrial production, along with a broad stock market rally, unnerved the Treasury market, which is always looking for someone or something to tell it what to do.
For those like myself who think the Fed will be forced to tighten more, not less, and who don't expect core inflation to decelerate, Tuesday's CPI report was sobering. (Color me impressed but doubtful.) No doubt Fed chief Alan Greenspan will seize on it when he testifies to the Joint Economic Committee of Congress and presumably forecasts clear sailing ahead.
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