By Michael Englund
Inflation likes to get off to an early start, if the chain-price inflation measures in the U.S. gross domestic product (GDP) and personal income reports are any indication. These reports often reveal substantial seasonal strength in inflation in the first quarter of the year. That's mainly because of cost-of-living adjustments (COLA) for the year in labor contracts and government-entitlement programs that aren't fully offset by seasonal factors. The effect is concentrated in the government sector, but emerges elsewhere as well.
Unfortunately for the markets, this time around the upside seasonal risk for first-quarter price measures will emerge just as the falling dollar and ugly inflation numbers for the fourth quarter are fueling growing concerns about rising prices in the U.S. financial markets. To make matters worse, the first-quarter figures this time will get an extra boost from the oil-led 2004 surge in headline inflation. That's because labor contracts and government COLA adjustment rules are based on the prior year's performance and generally make no exception for food and energy price changes.
The seasonal pattern in the quarterly inflation data from the GDP report has been substantial, both overall and in recent years. The past 10 years saw an average first-quarter chain-price gain of 2.3%, vs. average gains of 1.8% in the second quarter, 1.5% in the third, and 1.7% in the fourth.
This implies a hearty 0.6% first-quarter premium for chain prices over what appears to be a fairly stable pattern for the other three periods. Over the past five years the pattern has been stronger, with an average first-quarter chain-price gain of 2.7%, vs. averages of 2.2% in the second, 1.6% in the third, and 1.8% in the fourth, for an overall 0.8% first-quarter premium.
Distortions in the government sector largely explain the pattern. The average first-quarter chain-price gain for the government sector over the past 10 years has been a hefty 4.6%, vs. averages for the second, third, and fourth of 1.6%, 2.7%, and 2.5%, respectively, for an average first-quarter premium of 2.3%. Again, the five-year average shows a more powerful pattern, with averages of 5.3% in the first quarter, 2.1% in the second, 2.9% in the third, and 2.3% in the fourth, for a 2.8% first-quarter premium.
This time around, at Action Economics we cautiously expect a government chain-price growth rate of 4.6% in the first quarter of 2005, vs. a 3.5% gain in the 2004 fourth quarter. This should provide a solid boost to the overall first-quarter chain-price increase, which we estimate at a solid 3.0%. This gain follows our 2.1% overall estimate for the fourth quarter, and the surprisingly restrained 1.4% growth rate reported for the third.
Though this is a dramatic increase in reported inflation for the first-quarter data, the seasonal boost we assume is only about two-thirds of the prior pattern -- leaving upside risk to our estimate.
The first-quarter inflation figures contain three risks to the high side beyond the usual seasonal strength. First, as noted earlier, the unusual run-up in oil prices in 2004 has left a notable acceleration in headline inflation for the year. That implies that the cost of COLA adjustments in January should presumably exceed the usual seasonal tendency.
Second, U.S. domestic inflation measures are gaining steam, likely due to the combined effects of sustained rapid economic growth, ripple-through effects on nonoil prices from the 2004 oil price surge, and steady delayed effects of the two-year dollar decline. As such, the seasonal first-quarter rise in chain-price inflation may well heighten the market's fears, as the seasonal pattern isn't fully understood by market participants.
Third, Wall Street is increasingly pricing in a sustained downtrend in the dollar over the foreseeable future. Soaring current-account deficits, rapid growth in U.S. domestic demand alongside weakness in spending in Europe and Canada, and the downtrend already evident in the dollar -- despite massive and unsustainable efforts at currency-market intervention by foreign central banks through 2004 -- make it hard to argue with a pessimistic dollar forecast.
These three factors, taken together, mean the Federal Reserve may face damage-control issues as Chairman Alan Greenspan approaches both the two-day FOMC meeting ending Feb. 2, and his semi-annual congressional testimony later that month. The Fed's "measured" pace of policy tightening has made sense to many market participants in the context of the honeymoon inflation period that the Fed usually enjoys during the middle years of each business cycle. And the market no doubt remembers the Fed chief's tendency to prefer a "gradualist" policy approach that leaves interest rates generally low during these years -- counter to the preferences of the so-called bond market vigilantes, who are keenly sensitive to any stirrings of inflation.
The risk to Greenspan's approach is that the tightening trajectory might need to be stepped up more dramatically, and presumably more disruptively, if inflation unexpectedly gets ahead of the Fed. Though we think Greenspan still has some time to enjoy those cozy middle years of the expansion, the upside to prices that appears to be in the pipeline for the first quarter of 2005 may be enough to prompt a more preemptive policy rhetoric from the Fed at its February meeting.
Englund is chief economist for Action Economics