The January CPI's Deceptive Story

While consumer prices remain tame, inflation pressures continue to build on several fronts, especially in imports and producer prices

By Rick MacDonald

To an inflation-wary market, the January consumer price index (CPI) released Feb. 23 must have come as a relief. The report showed the overall index inched up just 0.1% for the month, below economists' median forecast of a 0.2% gain, while the core index, which excludes food and energy prices, rose 0.2%, in line with expectations.

But the tame January CPI numbers don't mean the U.S. is off the hook as far as inflation is concerned. The month's trade price and producer price index (PPI) data reveal considerable inflation pressure in the pipeline that should remain in place through at least the first half of 2005. Why do we at Action Economics think inflation pressure is building? Let's review the evidence:

Trade prices: The U.S. dollar has fallen steadily over the last three years from the all-time high set in February, 2002. Import prices have trended higher in response. Expected dollar weakness through the second half of 2005 will aggravate the outlook for import price inflation.

Indeed, Federal Reserve Chairman Alan Greenspan in his recent congressional testimony indicated that "although the dollar has been declining since early 2002, exporters to the U.S. apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins."

But the Fed chief pointed out that a quickening pace of increases in U.S. import prices suggests profit margins of exporters to the U.S. have contracted to the point where "foreign shippers may exhibit only limited tolerance for additional reductions in margins" should the dollar fall further.

Specifically, import prices from Asia have been surprisingly subdued, despite the region's sharp appreciation of currencies. But the huge gap between the currency and import prices that has evolved over the past three years may indeed have reached its limit.

Wholesale inflation: The January PPI report was significant for several reasons. It marked the sixth straight month that the core PPI measure has been well above its three-year average. And the 0.8% surge in the core figure appears to also signal a new willingness of producers to pass on price pressures to buyers following several years of limited pricing power. The January round of data also sustained a strong uptrend in the year-over-year figures for crude, intermediate, and finished-goods prices.

The difference between year-over-year growth in intermediate and finished goods inflation -- a measure of "wholesale pipeline inflation" -- is, shockingly, at the highest rate seen since the 1973-75 OPEC oil embargo, which is generally viewed as one of the largest "exogenous" cost-push inflation shocks in U.S. history.

Retail inflation: The January CPI core inflation data have also kept a strong year-over-year uptrend intact that is tracking the strength in wholesale inflation. Note that in the inflation acceleration of 1994-95 and 1998-99, wholesale inflation generally rose to the pace of retail inflation before subsiding. But this cycle has shown a much stronger upswing for wholesale inflation, with it now well above retail inflation.

In total, inflation pressure in the pipeline -- from rising prices for imported goods to surging wholesale and retail prices -- is signaling considerable risk for the 2005 inflation outlook. This mounting evidence of upside risk should keep the Fed on alert through at least the year's first half. Given this strength and the lags in inflation relative to growth, the Fed may see little opportunity for a pause in tightening in the second half of the year.

MacDonald is global director of investment research and analysis for Action Economics

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