Inflation: Is the Worst Over?

With oil costs easing, May price gains are likely to be muted. This will allow the Fed to continue its policy of small rate hikes

By Michael Englund

In his testimony to the Joint Economic Committee (JEC) of Congress on June 9, Federal Reserve Chairman Alan Greenspan had some reassuring words for financial markets. The Fed chief said the economy is on "reasonably firm footing." And on another topic that has caused some anxiety on Wall Street, he noted that underlying inflation remains "contained."

But will two government reports scheduled for release the week of June 13 -- data on wholesale and consumer prices -- muddy the inflation waters before the Fed chief and the rest of the rate-setting Federal Open Market Committee (FOMC) meet on June 30?

GAS-PRICE DROP.

  Most likely not. We at Action Economics think Greenspan's sanguine outlook on inflation will receive affirmation from the producer price index (PPI) and consumer price index (CPI) reports for May. The main reason? The slide in energy prices during the month.

First up comes May producer prices on June 14. We expect the overall PPI to drop 0.5%, vs. economists' median forecast of a 0.1% dip, while the core index, which excludes volatile food and energy prices, increases 0.2% (median also +0.2%). The decline in the overall index should be paced by commodity prices, which revealed a notable pullback on the month, led by energy. Wholesale gasoline prices are expected to drop more than 10%, while the overall energy aggregate is expected to slide 3% to 4%.

Our view of lessening price pressures on the wholesale front is confirmed by data in recent surveys of the nation's corporate purchasing managers by the Institute for Supply Management (ISM). The May price component from the ISM's manufacturing survey dropped from 71 to 58, while the price component from the nonmanufacturing survey fell from 61.9 to 57.9 -- the lowest level since August, 2003.

WIDESPREAD WEAKNESS.

  Evidence of moderating price pressure in May also manifested itself in the monthly trade-price report released on June 10. It revealed widespread declines in prices for both exports and imports. Petroleum-import prices fell as expected, by 6.5%. But import prices excluding petroleum dipped by an impressive 0.3%, with widespread weakness.

Export prices slipped by 0.1% in the month, with a hefty 0.4% decline if the volatile agricultural component is excluded. Agricultural prices for exports rose 2% -- thus extending a string of big gains since February -- even though other measures of food prices revealed restraint.

Both the the PPI and trade-price data should signal potential for a weak CPI report as well. At Action Economics, we expect the report, set for release on June 15, to show that overall CPI stayed the same in May (median +0.1%), while the core index increased 0.2% (median +0.2%).

WORST RUNUP OVER?

  As with the PPI, the CPI's big story of the month will be the sharp reversal in energy prices following the strength over the previous few months. But the market will also focus in on the core index to determine how factors other than energy are affecting prices. The longer-term trend here bears watching: We at Action Economics see core inflation on a year-over-year basis rising slightly, to 2.3%, from 2.2% in April.

That increase would extend the modest upward trend evident in the core data since the start of 2004. But it would also suggest that the core rate is moving higher at a gradual pace -- a speed likely acceptable to the central bank during these middle years of the expansion. Upside surprises in the core-inflation figures through 2005 may shake the market's near-term enthusiasm over moderating price growth, but at this stage such surprises appear unlikely.

Overall, we think the data from both the PPI and CPI releases should prove consistent with the view that the worst of the inflation runup has ended, although the most recent jump in oil prices -- putting them back near recent highs -- merits watching. Oil prices posted big gains through 2004 and the early months of 2005. But big energy-price corrections both at the end of 2004, and now in the second quarter of 2005, have kept oil moving sideways since the third quarter of last year, even despite the most recent upticks.

RATE HIKES.

  With hindsight, it appears that the inflation data for 2005 will reveal the same seasonal pattern evident over the prior three years of strong price gains in the first quarter of the year, followed by some reversal in the second quarter. The inflation rate has ratcheted up modestly each year -- as often occurs through expansions -- but the uptrend hasn't proven problematic.

How might May's inflation reports affect the Fed's thinking? Well, Greenspan gave no hint of a near-term pause in the FOMC policy trajectory in his JEC testimony. We believe that benign PPI and CPI figures for May will give the Fed further room to continue boosting rates at least a few more times -- including a quarter-point tightening at the June 30 meeting.

Like the chairman, we still believe the U.S. economy is on solid footing. That strength, coupled with decreasing price pressures, should keep Greenspan & Co. on their "measured" policy pace. We forecast a steady stream of rate hikes to bring the Fed funds target rate to 4% by yearend.

Englund is chief economist for Action Economics

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