Inflation Turns Up the Heat in February

But positive info from two regional indexes and an encouraging reading on jobless claims help offset the bad news, says Action Economics

With the Federal Reserve's March policy meeting less than a week away, a full menu of economic data reports released Mar. 15 gave Ben Bernanke & Co. plenty to chew on. The main course was data on wholesale inflation for February, and the numbers may have been a bit too spicy for the Fed. But that hotter-than-expected offering was tempered somewhat by weaker showings for two regional economic surveys, alongside an encouraging reading on first-time jobless claims.

Here is Action Economics' rundown of the Mar. 15 reports:

Producer Price Index: The February overall PPI surged 1.3%—sharply above economists' median forecast of a 0.5% increase—while the core index, which excludes food and energy prices, jumped 0.4% (median 0.2%). The energy aggregate increased 3.5%, on strong gains across the energy complex. Food prices revealed a 1.9% jump, which marks the third straight month that we have seen a gain of over 1%.

Unfortunately, the report wasn't just a headline story, as capital equipment prices were also firm, at 0.3%, and finished consumer-goods prices fully reversed their 1.5% drop last month. Intermediate and crude good prices more than reversed their declines last month as well. Though the year-over-year figures here are still benefiting from the "break" in the oil price uptrend last September and October, there's essentially no additional relief in the pipeline after the easy comparisons through last year's August price period disappear in the coming fall.

The mix left a huge bounce in year-over-year headline inflation, to 2.5% in February, from the 0.2% lull last month. And more importantly, the sustained core year-over-year inflation rate at 1.8%, boosted by the big 0.4% core increase, bucked the modestly easy comparisons that will remain in place for this measure until June.

The headline and core PPI pop for February, combined with the export price strength and petroleum price gains in the February trade price report on Mar. 14, suggest continued upside risk to our forecasts of a 0.3% headline gain in the headline February consumer price index, scheduled for release Mar. 16, along with a 0.2% core increase. The same headline and core mix is expected in the chain-price indexes for consumption on the month.

Philadelphia Fed and Empire State Indexes: The U.S. Philly Fed report revealed a small drop, to a 0.2 reading—below the median forecast of 4.0. The underlying data had a firmer tone, however, as orders, shipments, employees, and the work week all improved from February levels, while unfilled orders, deliveries, and inventories declined.

Meanwhile, the March Empire State index dropped to 1.85 (median 17.5) from February's stronger-than-expected level of 24.35. The sharp drop in the survey leaves the headline in this regional report more in line with the more subdued readings in other business sentiment surveys, after notably outperforming over the last six months.

Yet, for both surveys, the component data were considerably stronger than the headline figures, and it's the component data that are used to guide forecasts for the other sentiment indexes on the month. If we convert today's reports to an "ISM-adjusted basis," the Empire state reading sat at a respectable 53.4, while the Philly Fed bounced by nearly a point, to 49.8, with restraint due partly to a lean inventory reading that's unlikely to be matched in the other surveys.

Based on these figures, we will leave our other March sentiment forecasts at 50.5 for the Chicago purchasing managers' index, 50.5 for the Institute for Supply Management manufacturing index, and 56.5 for the ISM non-manufacturing index. The mix would leave the average ISM-adjusted index in the same 52 area as in February, following a lean 51 average in January, a 53 average in November and December, and an average within one tick of 55 in each of the prior five months.

The various indexes have generally posted a gradual drop-back to the sustainable 53 ISM-adjusted area as the expansion matures, but with downside overshoots through the 2006 fourth quarter and 2007 first quarter for some of these indexes that reflect the impact of the ongoing inventory correction.

Initial Jobless Claims: Initial jobless claims fell 12,000, to 318,000 (median 325,000), for the week ended Mar. 10. The moderation in initial claims from the Feb. 10 peak of 359,000 implies that much of the February run-up in initial claims was indeed weather related. Our March nonfarm payroll estimate sits at 160,000, following the payroll undershoots of 97,000 in February and 111,000 in January, but overshoots in November and December of 196,000 and 206,000 respectively. We do expect a moderation in payroll growth through 2007 from the 189,000 average in 2006, though the March figures may be boosted by "catch up" in the seasonal components of February.

The Fed Outlook: Policymakers are facing the usual late-cycle quagmire that dominates the final years of expansion, as inflation figures are predisposed to run hot, just as the pace of economic growth posts a cyclical moderation from the unsustainably high growth rates of the first three or four years.

Though the market is always quick to jump on the Fed-easing bandwagon, the risks for the central bank are clearly two-sided, with little rhetorical room for the FOMC to claim over the near term that inflation risks are subsiding. Since the last FOMC meeting, we have seen solid gains in wages, energy, food, and other prices, and a solid set of inflation figures seems likely in March as well.

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