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Inflation: A Case of Data Whiplash

By Michael Englund It has been quite a roller-coaster ride for U.S. inflation data so far this year. The mix of monthly data through the early part of 2003 has revealed larger-than-expected swings in some closely watched price gauges. Most pronounced has been the record plunge of 1.9% in the overall producer price index for April, released on May 15, following sizable 1% to 2% increases in each of the prior three months. The "core" index for this same measure, which excludes volatile food and energy prices, declined 0.9% -- the largest decrease in nearly 10 years -- following big gains through the first quarter.

What's going on here? While the April PPI decline was much steeper than expected -- and has sparked worries in some quarters about the emergence of deflation -- none of this is really much of a surprise. The markets certainly knew to expect a reversal in energy-related price gains through the first quarter, and the only real stunner was the speed with which declines in market prices were captured by the April inflation reports.

Indeed, though the PPI data for April reflected a surprisingly large chunk of the collapse in energy prices following the end of Gulf War II, there's still room for further energy-related price declines in the May and June reports. The aggregate PPI index soared by more than 4% through the first quarter, and only half of this runup has now been reversed. A hefty 23% decline was reported for gasoline prices in April, alongside an 8.6% drop for energy prices overall. These rapid drops will have ripple effects on other inflation measures, since most market prices are sensitive to energy-related transportation and production costs.

SOFT PRICES. A similar pattern was revealed in the May 16 release of consumer price data for April. The overall CPI dropped 0.3%, while the core index was unchanged. In the aggregate, while the CPI did not hold the shock value that the record drop in the PPI did, the report nonetheless underscores the benign inflationary environment by revealing that nearly all of the apparent "war premium" that accumulated in prices by this measure appeared to have unwound during April, with only residual remaining downside risk for May.

Though MMS sees little risk of outright deflation in the U.S. economy, the rapidity with which the downside price correction in wholesale oil markets worked its way to the retail end of the market suggests that corporations continue to face a lack of pricing power in their own markets.

As such, the April declines in the PPI and CPI raise the likelihood that the Federal Reserve could be more inclined to ease rates again. The Fed likely had a good idea of what kind of figures the April inflation reports contained. Given its deflation comments and risk assessment of weakness in the last FOMC policy statement, it's likely that Greenspan & Co. chose its words carefully to provide the necessary "smoking gun" at the start of the next meeting in June, should it choose to slice rates further (see BW Online, 5/9/03, "Why the Fed Is Ready to Cut Again").

BETWEEN THE LINES. And the markets could well have seen the weak April inflation reports coming, based on earlier reports of big price gyrations. The first-quarter gross domestic product report, the trade-balance data through March, the import and export price data through April, and all the available retail-sales data can be characterized as reflecting an unexpectedly large price rise through March, followed by a hefty price collapse in April.

A look at the price and volume trends (the degree to which price increases or decreases account for changes in dollar-denominated totals, vs. changes in the actual volume of activity) in all these reports indicate that the recent Fed shift in the wording of its balance-of-risk statement may have been well timed. This is certainly true to the extent that the goal was to leave the door open for a possible June easing. In our opinion, this was probably Fed Chairman Alan Greenspan's intent as he steered the debate over the statement's wording at the last meeting.

Many of the surprises peppering our forecasts over the past month have reflected a much bigger surge in reported prices for March than expected and a surprisingly rapid price collapse from that peak. We at MMS International use average daily prices for commodities such as petroleum to gauge price swings during a month before the release of the official reports, since volume-adjusted prices within each month aren't available.

PLAYING CATCH-UP. It now appears that there was a disproportionate volume of activity in March through the first half of the month, with high and rising petroleum prices, perhaps as refiners and shippers preemptively stocked goods. The result is that total activity in March occurred at higher prices than we assumed.

On the flip side, much of the weakness in April now reflects the much lower average prices for that month, as the declines that really started in mid-March play catch-up. The result is that the March data were actually all much weaker in "real" terms than we had assumed, while the April data are stronger than the nominal data seem to indicate.

The impact on the major economic releases has been huge. GDP for the first quarter revealed a stronger price gain and weaker inflation-adjusted gain than most economists calculated from reported nominal values. We now expect a slowdown in "chain-price" inflation -- the key inflation measure in the GDP report -- to a 0.9% rate in the second quarter, from the surprisingly large 2.5% rate in the first. Meanwhile, real GDP should accelerate to 2.5% in the second quarter, from 1.6% in the first.

BUCKING THE TREND. For retail sales, which are expected to post a nominal slowdown from 5.7% growth in the first quarter to an estimated 5.1% in the second, it appears that inflation-adjusted growth actually rebounded. Real consumption is rising in the second quarter at a 3.5% rate, from a 1.4% rate in the first, while the chain price deflator for consumption is expected to decelerate sharply to a flat reading in the second quarter, from the 2.8% rate reported for the first.

Finally, the trade-balance data through March revealed a swelling deficit during the first quarter due to rising oil prices, which cloaked an underlying improvement in the inflation-adjusted deficit. The huge 2.7% drop in import prices in April suggests that nominal imports will now fall in April as well, thus allowing the reported nominal deficits to stabilize in the $42 billion area just as the "real" trade figures resume a pattern of deterioration.

In real terms, net exports added a full percentage point to first-quarter GDP growth, but will likely subtract between one and two percentage points from growth in the current period, as the real data buck the nominal trend.

ONE MORE TIME? Our conclusions from these recent economic reports is that real growth is holding up fairly well through the first and second quarters. And it's worth noting that tax cuts are likely coming, and plenty of fiscal and monetary stimulus is already in the pipeline.

The Fed probably has a similar assessment, which creates an incentive for Greenspan to focus market attention on weak inflation data alone rather than the mixed signals in "real" data. With the current balance-of-risk statement on the table, the Fed can credibly ease one more time if it chooses at the June meeting, even as "real" data recover. Englund is chief economist for MMS International

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